Burwood Mining is raising capital of $500,000 for its next project from the following sources:
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Sources
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Amount $
|
|
Common stock
|
100,000
|
|
Preferred stock
|
50,000
|
|
Bank loan
|
150,000
|
|
Debenture
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100,000
|
|
Retained arnings
|
100,000
|
|
Total
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500,000
|
The annual return on the Treasury securities is 11%; the market index indicates that the average return on the market is 18%. The company has issued its debt instruments promising to pay interest of 15% p.a.. The company has also secured a bank loan at 14%. The Burwood company's equity beta has recently gone up to 1.4; such increase is due to the introduction of Carbon Tax. The company is subject to a tax rate of 35%. The company management has also decided to pay the holders of preferred stock 300 basis points less return than their common stock holders.
Scenario 1- The proposed new project is expected to bring an annual after tax cash flow of $100,000 forever. The project however faces a 20% probability of getting $70,000 annually, after paying tax, in perpetuity.
Scenario 2- Everything in the scenario 1 is the same except that if it is a failure the business would be worth only $300,000 at the end of the first year. You however are unsure of the probability of success and failure in this scenario.
Burwood Mining Ltd is also aware that a large competitor has expressed an interest in acquiring the project at the end of the first year for $400,000 regardless of the outcome of the expansion. The sale price would include any cash flows accrued during the first year of trading.
Question:
(i) Calculate the NPV of the project in scenario 1
(ii). Applying one of the option pricing models that you have learnt, value the abandonment option available to Burwood Mining Ltd in the form of a possible sale of the business to the large competitor company. Use the NPV that you obtained in Scenario 1 as the current value of Mining project.