GHY plc is evaluating two mutually exclusive projects, A and B. Project A is riskier than the average level of risk of the company, while Project B is of lower risk than average level of risk of the company. The cash flows of the projects are as follows: Project A (in €000) Year 0 Year 1 Year 2 Initial Probability Cash Flow Probability Cash Flow outlay 70% 260 40% 220 30% 210 -350 60% 200 60% 180 40% 160 Year 0 Initial outlay Year 2 Cash Flow Probability Project B (in €000) Year 1 Cash Flow Probability 40% 260 60% 45% 150 55% 310 35% 260 -350 180 65% 140 The company's overall cost of capital is 7% and the risk-adjusted rate for evaluating riskier/lower risk projects is +1% respectively.

Questions
1. Evaluate the projects using the NPV criterion.
2. Assume that the company has the option to liquidate the investment undertaken
under Question (a) above, for €200,000, at the end of the first year. Recalculate
the NPV of the project bearing in mind this option. Does the option increase the
NPV value or not? Why?

Answer 1)

We know that,

NPV of project = Present Value(PV) of Inflows - PV of Outflows.

Note :- All figures are in(€ 000)

Project A:-

Since it is riskier project discount rate of 8% will be used.

Now if CashFlow at year 1(CF1) upstream = 220, then

CF(2) upstream = 260*70% + 210*30% = 245

Now discount CF(1) and CF(2) to get NPV upstream i.e.

= 220/1.08 + 245/1.08² - 350

= 413.75 - 350 = 63.75

Similarly,

CF(3) downstream = 180 , then

CF(4) = 200*0.6 + 160*0.4

= 184

Hence NPV downstream = 180/1.08 + 184/1.08² - 350

= 324.41 - 350

= - 25.58

Expected NPV will now be :-

= NPV upstream*0.4 + NPV downstream*0.6

= 63.75*0.4 + (-25.58)*0.6

= 10.152

Project B:-

Discount rate of 6% will be used.

CF(1) upstream = 260  then,

CF(2) upstream = 310*0.4 + 260*0.6 = 280

NPV upstream = 260/1.06 + 280/1.06² - 350

= 494.5 - 350 = 144.5.

Now CF(3) downstream = 150 then,

CF(4) downstream = 180*0.45 + 140*0.55 = 158.

Thus,

NPV downstream = 150/1.06 + 158/1.06² - 350

= 282.13 - 350 = - 67.87.

Expected NPV of Project B is

= NPV upstream*0.35 + NPV downstream*0.65

= 144.5*0.35 + (-67.87)*0.65

= 6.46.

Conclusion:- Since Expected NPV of Project A is greater than Project B, Project A should be undertaken.

Answer 2)

It is given in question that Company has option to liquidate investment for €200( all figures in € 000) at first year end.

Now, Upstream second year Cashflow PV at end of year 1 is = 245/1.08 = 226.85.

This means company will not exercise abandonment option because it is greater than abandonment value of 200. Hence NPV upstream will remain unchanged i.e 63.75

Now, Downstream Second year Cashflow PV at end of year 1 is = 184/1.08 = 170.37.

This is less than abandonment value and company will exercise abandonment option here.

Therefore Revised NPV downstream now will be:-

= 180/1.08 + 200/1.08- 350

= 351.85 - 350

= 1.85

Expected NPV = 63.75*0.4 + 1.85*0.6

= 26.61.

Conclusion :-

Abandonment option increases NPV from 10.15 to 26.61 which is 16.46 because company will exercise this option at year 1 downstream as explained in question above.

Alternatively to cross check student can do this as well:-

Increase in value to due abandonment exercise at Year 1 downstream = (200 - 170.37) = 29.63

PV of abandonment option = (29.63/1.08)*0.6

= 16.46