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

question 8

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% and the discount rate is 12%.
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:

Producer Surplus

The contrast between the price at which producers are willing to part with a good or service and the price at which they actually do.

Hamburgers

A beloved dish featuring a patty made from minced meat, commonly beef, cooked and nestled within a cut-open bread bun or roll.

Consumer Surplus

The difference between the maximum amount a consumer is willing to pay for a good or service and the amount they actually pay.

Demand Curve

A visual diagram that illustrates the connection between a product's price and the amount consumers want to purchase.