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Chapter 7: Problem 29

Abandonment Decisions M.V.P. Games, Inc., has hired you to perform a feasibility study of a new video game that requires a \(\$ 5\) million initial investment. M.V.P. expects a total annual operating cash flow of \(\$ 880,000\) for the next 10 years. The relevant discount rate is 10 percent. Cash flows occur at year-end. 1\. What is the NPV of the new video game? 2\. After one year, the estimate of remaining annual cash flows will be revised either upward to \(\$ 1.75\) million or downward to \(\$ 290,000\). Each revision has an equal probability of occurring. At that time, the video game project can be sold for \(\$ 1,300,000\). What is the revised NPV given that the firm can abandon the project after one year?

Short Answer

Expert verified
The NPV of the new video game with the given cash flows is approximately $428,778. After one year, considering the possibility of abandonment and the revised cash flow estimates, the revised NPV is approximately $376,403.

Step by step solution

01

Calculate NPV given the initial data

First, let's calculate the NPV of the new video game with the given cash flows: \( NPV = -I + \sum_{t=1}^{n} \frac{CF_t}{(1+r)^t} \) Where: \(I = \$ 5,000,000\) (initial investment) \(n = 10\) (number of years) \(CF_t = $ 880,000\) (annual cash flow) \(r = 0.10\) (discount rate) \( NPV = -5,000,000 + \sum_{t=1}^{10} \frac{880,000}{(1+0.1)^t} \) Now, calculate the NPV of the new video game.
02

Calculate the revised NPV after one year

After one year, the estimate of remaining cash flows will be revised. At that time, the video game project can be sold for $1,300,000. We can create a decision tree with two scenarios after one year: 1. Upward revision of cash flows to $1.75 million 2. Downward revision of cash flows to $290,000 For each scenario, we need to calculate the NPV: Scenario 1 - Upward revision to $1.75 million: \( NPV_1 = \frac{1,300,000}{(1+0.1)^1} + \sum_{t=2}^{10} \frac{1,750,000}{(1+0.1)^t} - 5,000,000 \) Scenario 2 - Downward revision to $290,000: \( NPV_2 = \frac{1,300,000}{(1+0.1)^1} + \sum_{t=2}^{10} \frac{290,000}{(1+0.1)^t} - 5,000,000 \) Since each scenario has an equal probability of occurring, the revised NPV will be the average of the two NPVs: \( Revised \: NPV = \frac{NPV_1 + NPV_2}{2} \) Now, calculate the revised NPV given that the firm can abandon the project after one year.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Net Present Value (NPV)
The Net Present Value (NPV) is a financial metric used to assess the profitability of an investment. It represents the difference between the present value of cash inflows and the present value of cash outflows over a period of time. In essence, NPV is used to determine whether the expected earnings (discounted back to their present value) exceed the initial investment.

In the given exercise, the NPV for a new video game development project was calculated by subtracting the initial investment from the summation of discounted future cash flows. A positive NPV implies that the project is expected to generate more cash than it costs, while a negative NPV indicates the opposite. NPV is a critical tool in capital budgeting and provides a straightforward indicator of an investment's potential to increase the company's value.
Discount Rate
The discount rate is a pivotal concept in financial analysis and investment decision-making. It is the rate used to discount future cash flows back to their present value. This rate can reflect the cost of capital, the opportunity cost of choosing one investment over another, or the risk associated with the future cash flows.

In the context of our case study, the discount rate of 10 percent reflects the expected return required by M.V.P. Games for its investment in the new video game. The discount rate is pivotal in calculating the Net Present Value and determining the feasibility of a project, as a higher discount rate would increase the hurdle for future cash flows to be considered beneficial.
Cash Flow Estimation
Cash flow estimation is the process of predicting the amount of money that will move in and out of a business during a future period. It's a core part of investment analysis because it directly influences the Net Present Value calculation.

In the provided exercise, the estimated annual operating cash flow for the video game project is $880,000 for ten years. It's crucial to perform accurate cash flow estimations to avoid underestimating or overestimating an investment's potential. Estimating cash flows requires considering factors like market demand, production costs, and sales revenues. The level of accuracy in these estimations can significantly impact the investment decision.
Feasibility Study
A feasibility study is a comprehensive analysis of the viability of an idea, such as the development of a new product, in this case, a video game. The study helps in identifying potential problems and determining if the investment is likely to succeed before substantial resources are committed.

For M.V.P. Games, the feasibility study involves analyzing the projected cash flows and comparing them to the initial investment and operating costs. Part of the study also includes the consideration of possible future scenarios, such as the upward or downward revision of cash flows and the option to abandon the project if it becomes unfeasible.
Investment Analysis
Investment analysis involves evaluating an investment for profitability and risk to inform business decisions. It combines various financial techniques, including NPV, to assess whether an investment is sound.

The primary aim of investment analysis in this problem is to determine the project's value under different cash flow scenarios and to identify the most financially advisable course of action. M.V.P. Games must weigh the initial costs, projected cash flows, and potential future developments to decide whether developing the video game would be a beneficial use of the company's resources.
Decision Tree Analysis
Decision tree analysis is a visual tool for mapping out and analyzing the various possible outcomes of a decision. It helps to make informed decisions by considering both the likelihood and impact of certain events.

In this scenario, after one year, M.V.P. Games has the option to abandon the project. A decision tree is used to evaluate this decision by calculating the revised NPV of continuing the project with new cash flow estimates versus selling it off. The decision that provides the highest NPV would then guide the company's strategy. This approach acknowledges uncertainty and allows decision-makers to plan for various potential future states.

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Most popular questions from this chapter

Scenario Analysis Consider a project to supply Detroit with 55,000 tons of machine screws annually for automobile production. You will need an initial \(\$ 1,700,000\) investment in threading equipment to get the project started; the project will last for five years. The accounting department estimates that annual fixed costs will be \(\$ 520,000\) and that variable costs should be \(\$ 220\) per ton; accounting will depreciate the initial fixed asset investment straight-line to zero over the five-year project life. It also estimates a salvage value of \(\$ 300,000\) after dismantling costs. The marketing department estimates that the automakers will let the contract at a selling price of \(\$ \mathbf{2 4 5}\) per ton. The engineering department estimates you will need an initial net working capital investment of \(\$ 600,000\). You require a 13 percent return and face a marginal tax rate of 38 percent on this project. 1\. What is the estimated OCF for this project? The NPV? Should you pursue this project? 2\. Suppose you believe that the accounting department's initial cost and salvage value projections are accurate only to within \pm 15 percent; the marketing department's price estimate is accurate only to within \pm 10 percent; and the engineering department's net working capital estimate is accurate only to within \pm 5 percent. What is your worst-case scenario for this project? Your best-case scenario? Do you still want to pursue the project?

Decision Trees Young screenwriter Carl Draper has just finished his first script. It has action, drama, and humor, and he thinks it will be a blockbuster. He takes the script to every motion picture studio in town and tries to sell it but to no avail. Finally, ACME studios offers to buy the script for either (a) \(\$ 12,000\) or (b) 1 percent of the movie's profits. There are two decisions the studio will have to make. First is to decide if the script is good or bad, and second if the movie is good or bad. First, there is a 90 percent chance that the script is bad. If it is bad, the studio does nothing more and throws the script out. If the script is good, they will shoot the movie. After the movie is shot, the studio will review it, and there is a 70 percent chance that the movie is bad. If the movie is bad, the movie will not be promoted and will not turn a profit. If the movie is good, the studio will promote heavily; the average profit for this type of movie is \(\$ 20\) million. Carl rejects the \(\$ 12,000\) and says he wants the 1 percent of profits. Was this a good decision by Carl?

Project Analysis You are considering a new product launch. The project will cost \(\mathbf{\$ 9 6 0 , 0 0 0}\), have a four-year life, and have no salvage value; depreciation is straight-line to zero. Sales are projected at 240 units per year; price per unit will be \(\$ 25,000\); variable cost per unit will be \(\$ 19,500\); and fixed costs will be \(\$ 830,000\) per year. The required return on the project is 15 percent, and the relevant tax rate is 35 percent. 1\. Based on your experience, you think the unit sales, variable cost, and fixed cost projections given here are probably accurate to within \pm 10 percent. What are the upper and lower bounds for these projections? What is the base-case NPV? What are the best-case and worst-case scenarios? 2\. Evaluate the sensitivity of your base-case NPV to changes in fixed costs. 3\. What is the accounting break-even level of output for this project?

Option to Wait Hickock Mining is evaluating when to open a gold mine. The mine has 60,000 ounces of gold left that can be mined, and mining operations will produce 7,500 ounces per year. The required return on the gold mine is 12 percent, and it will cost \(\$ 14\) million to open the mine. When the mine is opened, the company will sign a contract that will guarantee the price of gold for the remaining life of the mine. If the mine is opened today, each ounce of gold will generate an aftertax cash flow of \(\$ \mathbf{4 5 0}\) per ounce. If the company waits one year, there is a 60 percent probability that the contract price will generate an aftertax cash flow of \(\$ 500\) per ounce and a 40 percent probability that the aftertax cash flow will be \(\$ 410\) per ounce. What is the value of the option to wait?

Decision Trees The manager for a growing firm is considering the launch of a new product. If the product goes directly to market, there is a \(\mathbf{5 0}\) percent chance of success. For \(\$ 135,000\) the manager can conduct a focus group that will increase the product's chance of success to 65 percent. Alternatively, the manager has the option to pay a consulting firm \(\$ 400,000\) to research the market and refine the product. The consulting firm successfully launches new products 85 percent of the time. If the firm successfully launches the product, the payoff will be \(\$ 1.5\) million. If the product is a failure, the NPV is zero. Which action will result in the highest expected payoff to the firm?
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