solution

1. You are given the following information on a project with a 5-year life that requires an initial investment of $500,000. If things go well (with probability 0.60) the project will generate $200,000 for each of the years 1-5. If not, (with probability 0.40) the cash flows will be -$20,000 per year for each of the years 1-5.

Assume that the project’s beta is 0.75, the expected Market return is 12.0%, and the risk-free rate is 4.0%. Further, the firm plans to finance the project with $300,000 of equity and $200,000 in debt. The YTM on the company’s bonds is 6.0% and its marginal tax rate is 25%. [Use Discrete compounding throughout].

1. Using relevant information compute the project’s WACC.
2. Compute the project’s NPV without any Real Option to Abandon.
3. Compute the project’s IRR without any Real Option to Abandon.
4. Now assume, the firm has the option to abandon the project after 2 years. What is the value of this option to abandon? Compute the project’s NPV with the Real Option to Abandon.
5. Compute the project’s IRR with the Real Option to Abandon.