You work as a financial analyst for Athens Development Corpo

You work as a financial analyst for Athens Development Corporation. The company is considering a new product that is sensitive to the economic conditions as well as consumer demand. The capital investment requires an initial outlay of $150.000 to buy a specialized machine to produce the new product. If the demand is good in the first year, the project is expected to bring cash flow of $100,000 with a probability of .6 But if the demand is bad in the first year, the project is expected to bring cash flow of $50,000 with a probability of .4. If the demand is good in the first year, then the project is expected to bring second year cash flow of $120,000 if the demand is good in the second year with a probability of .6 but bring cash flow of $90,000 if the demand is bad in the second year with a probability of 4. If the demand is bad in the first year, then the project is expected to bring secot year cash flow of $50,000. At a 8% of required rate of return, find each possible Net Present Value its associated probability. Should the company make the new investment?

Solution

The Cash flow , the associated probabilities and the expected Cash flow are :

Year 1 (Good)$100000 *0.60 + (Bad) $50000 * 0.40 = Expected Cash flow $ 80,000   

  

year 2   Good - Good Good - Bad Bad - Bad

(with parent weightage) 120,000 * 0.60 * 0.60 + 90,000 * 0.40 * 0.60 + $50000 * 0.40 = Expected C F $84800

weightage)

Present Value of above expected Cash Flow and Net Present Value of new investment :

The Company should not make the new investment as it will incure negative NPV of expected Cash Flow of ($3246.4).

year	cash flow	expected cashflow	discount rate 8%	present value
0	($150000)		1	($150000)
1		$80,000	0.926	$74,080
2		$84,800	0.857	$72,673.60
			Present Value of expected cash flow	($3246.40)