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Lincoln Restaurants is introducing a new product this year. If "glow in the dark hamburgers" are a hit, the firm expects to be able to sell 500 units a year at a price of $6 each. If the new product is a bust, only 300 units can be sold at a price of $5. The variable cost of each ball is $3, and fixed costs are zero. The cost of the manufacturing equipment is $7000, 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 30% and the discount rate is 10%.
a. If each outcome is equally likely (50%), what is expected NPV of "glow in the dark hamburgers"? Will the firm accept the project?
b. Suppose now that the firm can abandon the project and sell off the manufacturing equipment for an after-tax $6,500 if demand for the burgers turns out to be weak (YOU CAN IGNORE TAXES ON THE SALVALGE VAUE OF THE EQUIPMENT). The firm will make the decision to continue or abandon after the first year of sales. Considering the ability to abandon the project early, what is the new NPV? What is the value of the option to abandon? Does the option to abandon change the firm's decision to accept the project?
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