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C,a ferry company,is considering leasing a car ferry to service a new route.The project will run for three years.The initial setup costs are $150000,if C,uses Ferry X.Alternatively C could pay more to secure the use of Ferry Y.The annual total running and leasing costs will be $ 300000,for either ferry.Ticket sales are difficult to predict,but C believes that the first year sales would be replicated in each of the second and third years.Annual sales will be 250000 or 750000 with each possibility being equally likely.The project will be abandoned in the event that the first year sales are 250000.If C leases a ferry X,then the contract will require the lease payment to be made in year 2 or year 3 even if the project is abandoned.If C leases Ferry Y then it will be possible to cancel the lease at the end of year 1 without penalty.C’s required rate of return is 10%.Calculate the maximum setup costs that C should be willing to pay in order to secure the use of Ferry Y.
I am really confused how to solve it
Hi – Thanks for your question.
Presumably you were given a model answer in the book? Can you tell me what the answer says and which part you need explaining? (this is better than me writing it all out).
Many thanksThey have just given the answer 386700 no explanation at all.I wanted to know that should I use Present value table ?
Hi,
Ok so this is a NPV problem so yes you need the discount tables for 10% – but I’m afraid I’ve not got the same answer as the textbook.This question is one where you have two identical projects but one project (ferryY) has an option to abandon in year 2 if the sales are low and the ferry is loss making. We need to find how much that ability to avoid the losses in years 2 and 3 is worth (i.e. what is the present value of the option to abandon).
There is some debate whether the valuation of abandonment options is beyond the scope of CIMA P2 ( the text books seem to suggest an understanding of abandonment options is required rather than a calculation of the value) -but anyway….
To value the option the method is to compare the NPV for the project with the abandonment option to the NPV of the project without the abandonment option..
Ferry X is the ‘without an option to abandon.
Ferry Y is the project with an option to abandon.NPV for ferry X
This includes cost of ferry
(150,000)
50% chance there may be poor sales with costs taken out 250,000 -300,000 = (50,000) loss years 1 to 3
or 50% chance may be good sales less costs = 750,000 -300,000 = 450,000 profit years 1 to 3.
The NPV of this ferry is $347400i.e.) -150,000 +(50% x (-50,000 x 2.487) ) +(50% x (450,000 x2.487) =$347400
Compare this to Ferry Y where the cost and the good years sales still stay the same but in the event of the bad sales the losses will be -50,000 in year 1 only and no costs or losses or revenue in year 2 or year 3
so the NPV is-150,000 + (50% x (-50,000 x 0.909)) + (50% x (450,000 x2.487) = $386,850
So yes the ferry Y avoids the losses in years 2 and years 3 so it has a higher present value than the other ferry. The value of the abandonment option is the difference between the two 386,850 -347,400 =$39,450
Hopefully you agree with the calculation and reasoning above despite the fact it doesnt match the model answer…
Kind Regards
CathAfter going through the CIMA P2 practice questions and wondering how they’ve come up with the calculations (even with the model answer), this has made the question clearer even though you’ve come up with a different answer. Thank you.
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