Answer:
Broadway Inc.
a. NPV of the project:
= $120,000 ($1,000,000 - 880,000)
b. Expected NPV of the project if the company cannot abandon the project:
= $120,000 ($1,000,000 - 880,000)
c. True NPV if the company can abandon the project after the first year:
= NPV = $74,080 - $880,000
= -$805,920
d. Value of the option to abandon:
= NPV = $74,080 - $880,000
= -$805,920
Explanation:
a) Data and Calculations:
Initial investment cost = $880,000
Assumed cost of capital = 8%
Expected annual free cash inflow = $80,000 in perpetuity
NPV = PV of Cash inflows minus PV of Cash outflows
PV of a perpetuity = Expected Annual Cash Inflows divided by cost of capital
= $80,000/0.08
= $1,000,000
$80,000 * 0.926 = $74,080
NPV = $74,080 - $880,000
= -$805,920
b) Broadway's Present Value of its perpetual annual cash inflow is calculated by dividing the cash inflow by the rate of interest, which is the cost of capital.
