You are planning to produce a new action figure called "Hillary". However, you are very uncertain about the demand for the product. If it is a hit, you will have net cash flows of $50 million per year for three years (starting next year [i.e., at t = 1]). If it fails, you will only have net cash flows of $10 million per year for two years (also starting next year). There is an equal chance that it will be a hit or failure (probability = 50 percent). You will not know whether it is a hit or a failure until the first year's cash flows are in . You have to spend $80 million immediately for equipment and the rights to produce the figure. If you can sell your equipment for $60 million immediately after the first year's cash flows are received, calculate Hillary's NPV with this abandonment option. (The discount rate is 10 percent. The equipment can only be resold at the end of the first year.)
A)−9.10
B)+9.10
C)+13.99
D)−14.40

Question

Quizplus · Accepted Answer

To calculate the NPV, we need to find the present value of all cash inflows and outflows in today's dollars.

If Hillary is a hit:
- First year cash inflow: $50 million 
- Second year cash inflow: $50 million 
- Third year cash inflow: $50 million

PV of cash inflows (hit scenario): 
$50 million / (1 + 10%) = $45.45 million (for all three years)

PV of upfront cost: 
-$80 million

PV of equipment resale value: 
$60 million / (1 + 10%) = $54.55 million

Net present value (hit scenario): 
$45.45 million - $80 million + $54.55 million = $20 million

If Hillary fails:
- First year cash inflow: $10 million 
- Second year cash inflow: $10 million

PV of cash inflows (failure scenario): 
$10 million / (1 + 10%) = $9.09 million (for both years)

PV of upfront cost: 
-$80 million

PV of equipment resale value: 
$60 million / (1 + 10%) = $54.55 million

Net present value (failure scenario): 
$9.09 million - $80 million + $54.55 million = -$16.36 million

The probability of Hillary being a hit or failure is equal, so we can find the expected NPV by taking the average of the NPVs calculated in each scenario:

Expected NPV: 
($20 million + (-$16.36 million)) / 2 = $1.82 million

Finally, we need to subtract the initial investment from the expected NPV to find the NPV with abandonment option:

Hillary's NPV with abandonment option: 
$1.82 million - $80 million + $54.55 million = $13.99 million

Therefore, the best choice is C.

You Are Planning to Produce a New Action Figure Called