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Water Factory NPV

Please solve manually instead of using Excel. I'm trying to grasp the concepts.

ABC is considering building a drilling for water factory. The equipment will cost $625 today, and in one year it will be known whether or not there is water at the site and, therefore, whether the project a success or failure. Engineering estimates a 60% chance of success. Finance has calculated the PV at t =1 for successful project to be $1,000 and the PV for a failure at t = 1 to be $0. Finance uses a discount rate of 10%.

a. Calculate the NPV today using a traditional NPV analysis. Should I reject or accept the project.

b. Assume Finance has determined that if the project is a failure, the equipment could be sold for $400 at t=1. When you include this abandonment option, what is the NPV of the project? Should I reject or accept the project.

c. Based on your answers to a. and b, calculate the value of the option to abandon.

Solution Preview

Part A
Investment = $625 (cash outflow)
If the project is a success the PV of the inflows is equal to $1,000 at t =1. This is equal to a PV of $1,000/1.1 = $909.09 at t = 0.
If the project is a ...

Solution Summary

This solution evaluates a project (drilling for a water factory) based on NPV analysis and project options.