Asked by Lourdes Orellana on Apr 26, 2024
Verified
Merritt Company is considering a new project that has a cost of $1,000,000,and the CFO set up the following simple decision tree to show its three most likely scenarios.Merritt could arrange with its work force and suppliers to cease operations at the end of Year 1 should it choose to do so,but to obtain this abandonment option,Merritt would have to make a payment to those parties.How much is the option to abandon worth (in thousands) to Merritt? WACC=11.5% Dollars in Thousands t=10 Prob =25% Prob =50%−$1,000 Prob =25% NPV this Prob ×t=1t=2t=3 State NPV $800.0$800.0$800.0$938.1$234.5$520.0$520.0$520.0$259.8$129.9−$200.0−$200.0−200.0−$1,484.5−$371.1\begin{array}{l}\begin{array}{lll}\mathrm{WACC}=11.5 \%& \text { Dollars in Thousands }\\&t=10\\\hline \text { Prob }=25 \% & \\\text { Prob }=50 \% & -\$ 1,000 \\\text { Prob }=25 \%\end{array}\begin{array}{lll} \text { NPV this } &\text { Prob } \times\\t=1 & t=2 & t=3 & \text { State } & \text { NPV } \\\hline \$ 800.0 & \$ 800.0 & \$ 800.0 & \$ 938.1 & \$ 234.5 \\\$ 520.0 & \$ 520.0 & \$ 520.0 & \$ 259.8 & \$ 129.9 \\-\$ 200.0 & -\$ 200.0 & -200.0 & -\$ 1,484.5&-\$ 371.1\end{array}\end{array}WACC=11.5% Prob =25% Prob =50% Prob =25% Dollars in Thousands t=10−$1,000 NPV this t=1$800.0$520.0−$200.0 Prob ×t=2$800.0$520.0−$200.0t=3$800.0$520.0−200.0 State $938.1$259.8−$1,484.5 NPV $234.5$129.9−$371.1
Exp −$6.7 NPV \begin{array}{r}\text { Exp }-\$ 6.7 \\\text { NPV }\end{array} Exp −$6.7 NPV
A) $68.8
B) $72.5
C) $76.3
D) $80.1
Decision Tree
A form of scenario analysis in which different actions are taken in different scenarios.
Abandonment Option
Allows a company to reduce the capacity of its output in response to changing market conditions. This includes the option to contract production or abandon a project if market conditions deteriorate too much.
WACC
The Weighted Average Cost of Capital provides a measure for a company's cost of capital, where each type of capital is assigned a weight based on its proportion.
- Comprehend the theory and process behind computing net present value (NPV) for decisions regarding project investments.
- Evaluate the effects of project hazards and modifications in operations on the valuation of the project.
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Learning Objectives
- Comprehend the theory and process behind computing net present value (NPV) for decisions regarding project investments.
- Evaluate the effects of project hazards and modifications in operations on the valuation of the project.
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