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 3 years (starting next year). If it fails, you will only have net cash flows of
$10 million per year for 2 years (starting next year). There is an equal chance that it will be a hit or failure (probability = 50%). 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 once the first year's cash flows are received, calculate the NPV with the abandonment option. (The discount rate is 10%)
A) -9.1
B) +9.1
C) +13.99
D) -14.4

Question

Quizplus · Accepted Answer

To calculate the NPV with the abandonment option, we need to find the expected value of each scenario and then calculate the present value of those cash flows.

Expected value of cash flows if it is a hit: 
EV(Hit) = (0.5)*$50 million + (0.5)*(-$80 million + $60 million + $50 million) = $40 million

Expected value of cash flows if it fails: 
EV(Failure) = (0.5)*$10 million + (0.5)*(-$80 million + $60 million + $10 million) = -$30 million

Next, we need to calculate the present value of these cash flows using a discount rate of 10%.

PV(Hit) = $40 million / (1 + 0.1) + $40 million / (1 + 0.1)^2 + $40 million / (1 + 0.1)^3 = $95.52 million

PV(Failure) = -$30 million / (1 + 0.1) + -$30 million / (1 + 0.1)^2 = -$49.59 million

The NPV with the abandonment option is:

NPV = -$80 million + $95.52 million + (-$49.59 million) = $13.93 million

Since the NPV is positive, it is worth proceeding with the project. The best choice is C.

You Are Planning to Produce a New Action Figure Called