(Abandonment Option) Hit or Miss Sports Is Introducing a New

question 86

Essay

(Abandonment Option) Hit or Miss Sports is introducing a new product this year.If its "see-at-night" soccer balls are a hit, the firm expects to be able to sell 50,000 units a year at a price of $60 each.If the new product is a bust, only 30,000 units can be sold at a price of $55.The variable cost of each ball is $30, and fixed costs are zero.The cost of the manufacturing equipment is $6 million, and the project life is estimated at 10 years.The firm will use straight-line depreciation over the 10-year life of the project.The firm's tax rate is 35 percent and the discount rate is 12 percent.
a.If each outcome is equally likely, what is expected NPV? Will the firm accept the project?
b.Suppose now that the firm can abandon the project and sell off the manufacturing equipment for $5.4 million if demand for the balls turns out to be weak.The firm will make the decision to continue or abandon after the first year of sales.Does the option to abandon change the firm's decision to accept the project?

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Definitions:

Deferred

Describes expenses or incomes that have been incurred but not yet realized, affecting financial statements in subsequent periods.

Released

In economic or financial contexts, this term usually refers to information, products, or assets that have been made available to the public or specific markets.

Absorption Costing

In this accounting procedure, the full scope of manufacturing costs, covering direct materials, direct labor, and both kinds of manufacturing overhead—variable and fixed—is accounted for in the product's pricing.

Ending Inventory

The total value of goods available for sale at the end of an accounting period.