Allied Products, Inc., is considering a new product launch. The firm e

QUESTION

Allied Products, Inc., is considering a new product launch. The firm expects to have an annual operating cash flow of $25 million for the next 10 years. Allied Products uses a discount rate of 20 percent for new product launches. The initial investment is
$100 million. Assume that the project has no salvage value at the end of its economic life.
a. What is the NPV of the new product?
b. After the first year, the project can be dismantled and sold for $50 million. If the estimates of remaining cash flows are revised based on the first years experience, at what level of expected cash flows does it make sense to abandon the project?
Solution: Annual operating cash flows = $25 million No of years = 10 Discount rate = 20% PV Annuity factor (n=10, r=20%) = 4.1925 PV of Annual operating cash flows = $25*4.1925 = $104.81 million Initial Investment = $100 million a. NPV = 104.81 100= $4.81 million Salvage value after 1 year = $50 million PV Annuity factor (n=9, r=20%) = 4.0310 In order to abandon the project the cash flow should such¦

hat the NPV is negative. The NPV will be 0, at x level of annual operating cash flows PV of Annual operating cash flows = $x*4.0310 = $50 million X = $12.40 million So, if the annual cash flows are below $12.40 million then is advisable to abandon the project.

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