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    New project: NPV, opportunity cost, abandonment value

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    We are examining a new project. We expect to sell 500 units per year at $20 net cash flow a piece for the next 10 years. In other words, the annual operating cash flow is projected to be $20 x 500 = $10,000 per year. The relevant discount rate is 20%, and the initial investment is $55,000.

    a) What is the NPV?
    b) After the first year, the project can be dismantled and sold for $40,000. If expected sales are revised based on the first year's performance, when would it make sense to abandon the investment? In other words, at what level of expected sales would it make sense to abandon the project?
    c) Explain how the $40,000 abandonment value can be viewed as the opportunity cost of keeping the project in one year.

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    Solution Preview

    Since I am not sure which kind of financial calculator you are using, I am solving this question using the general annuity formula

    P = R * { [ 1 - (1 - 1/(1 + i)^n] / i }
    where P is the principal or the present value of annuity
    R is the periodic payment in an annuity
    i is the discount rate
    n is the number of period (payment)
    Please input the corresponding values to whatever financial calculator you are ...

    Solution Summary

    This solution provides calculations and explanations for NPV, opportunity cost and abandonment value.