Q. No.

Ex-1
2
3
Prob-1
2
3
4
5
6
8
10
Topic Covered
EV & SD of the project & probability of various NPVs of dependent projects
EV and SD of the probability distribution of the possible consisting existing & new products
Cash flows with probability of success and failure, investment inbetween & NPV analysis
Expected vaklue & Standard deviation of the project & probability of various NPVs
EV & SD of the project & probability of various NPVs of independent dependent projects
Joint probability and calculation of NPV
Mean NPV & calculation of SD
Dominance of one project over the other, probability of NPV greater than zero
Comparision of projects interms of NPV and SD
NPV analysis and investment in between the life of the project, probability analysis & NPV
Joint probability and calculation of mean NPV
Q1-
Gomez Drug Product Company could invest in a new drug investment project with an estimated
life of three years. If the demand for the new drug in the first period is favorable, it is almost
certain that it will be favorable in periods 2 and 3. By applying the same token, if demand is low
in the first period, it will be low in the two subsequent periods as well. Owing to this likely demand
relationship, an assumption of perfect correlation of the cash flows over time is appropriate.
The cost of the project is $1 million and possible cash flows of the three periods are:
Probability Cash Flows Probability Cash Flows Probability Cash Flows
0.10 - 0.15 100,000 0.15 -
0.20 200,000 0.20 400,000 0.20 150,000
0.40 400,000 0.30 700,000 0.30 300,000
0.20 600,000 0.20 1,000,000 0.20 450,000
0.10 800,000 0.15 1,300,000 0.15 600,000
a- Assuming that risk-free rate is 8 percent and that it is used as discount rate, calculate
the expected value and standard deviation of probability distribution of possible net
present values.
b- Assuming a normal distribution, what is the probability of the project providing a
net present value of (1) zero or less ? (2) 300,000 or more ? (3) 1,000,000 or more ?
c- is the standard deviation calculated larger or smaller than it would be under assumption
of independence of cash flows over time?
Ans1a- Expected Value
Expected Expected Expected
Probability Cash Flows Value Probability Cash Flows Value Probability Cash Flows Value
0.10 - - 0.15 100,000 15,000 0.15 - -
0.20 200,000 40,000 0.20 400,000 80,000 0.20 150,000 30,000
0.40 400,000 160,000 0.30 700,000 210,000 0.30 300,000 90,000
0.20 600,000 120,000 0.20 1,000,000 200,000 0.20 450,000 90,000
0.10 800,000 80,000 0.15 1,300,000 195,000 0.15 600,000 90,000
400,000 700,000 300,000
Period 3 Period 2 Period 1
Period 1 Period 2 Period 3
Standard Deviation
(CF - Mean)^2 X (CF - Mean)^2 X (CF - Mean)^2 X
Probability Cash Flows Probability Probability Cash Flows Probability Probability Cash Flows Probability
0.10 - 16,000,000,000 0.15 100,000 54,000,000,000 0.15 - 13,500,000,000
0.20 200,000 8,000,000,000 0.20 400,000 18,000,000,000 0.20 150,000 4,500,000,000
0.40 400,000 - 0.30 700,000 - 0.30 300,000 -
0.20 600,000 8,000,000,000 0.20 1,000,000 18,000,000,000 0.20 450,000 4,500,000,000
0.10 800,000 16,000,000,000 0.15 1,300,000 54,000,000,000 0.15 600,000 13,500,000,000
Sum of all prob = a 48,000,000,000 Sum of all prob = a 144,000,000,000 Sum of all prob = a 36,000,000,000
Square Root of a = 219,089 Square Root of a = 379,473 Square Root of a = 189,737
Ans1b-
The standard deviation of the probability distribution of possible net present value under assumption of perfect correlation of cash flows
over time:
= 219,089 + 379,473 + 189,737
(1.08)^1 (1.08)^2 (1.08)^3
= 219,089 + 379,473 + 189,737
1.080 1.166 1.260
= 202,860 + 325,337 + 150,619
678,816
The mean net present value of the project =
NPV = -1,000,000 + 400,000 + 700,000 + 300,000
(1.08)^1 (1.08)^2 (1.08)^3
NPV = -1,000,000 + 400,000 + 700,000 + 300,000
1.080 1.166 1.260
-1,000,000 370,370 + 600,137 + 238,150
208,657
Period 1 Period 2 Period 3
= X - NPV
Probability
Zero or less 0 - 208657 = -208,657 -0.307
678,816 678,816
300,000 or more = 300000 - 208657 = 91,343 0.135
678,816 678,816
1,000,000 or more = 1000000 - 208657 = 791,343 1.166
678,816 678,816
Ans1c-
From Table C, these standardized differences corresponds to the probabilities of 0.38, 0.45 and 1.2,
respectively. The standard deviation calculated under this assumption is much larger than under an
assumption of independence of cash flows over time.
Q2-
Zell Company would like a new product line- Puddings. The expected value of standard deviation
of the probability distribution of of possible net present value for the product line are $12,000 and 9,000
respectively. The company existing lines are, ice cream, cottage cheese and yogurt. The expected value
of the net present value and standard deviation for the product lines are:
Net Present Value
Ice Cream 16000 8,000
Cottage Cheese 20000 7,000
Yogurt 10000 4,000
The correlation coefficient between the products are:
Ice Cream Cottage Cheese Yogurt
Ice Cream 1.00
Cottage Cheese 0.90 1.00
Yogurt 0.80 0.84 1.00
Puddings 0.40 0.20 0.30
a- Compute the expected value and standard deviation of the probability distribution of the possible
net present values for a combination consisting existing products.
b- Compute the expected value and standard deviation for a combination consisting of existing product
plus Puddings. Compare your results in part a and b. What can you say about the pudding line.
Ans2a- Existing Product
Expected Net Present Value
Product Net Present Value
Ice Cream 16000
Cottage Cheese 20000
Yogurt 10000
46000
Standard Deviation
Standard deviation =

( (
1
2
+ (2 X (1 X 2) X 0.9) +
2
2

+ (2 X (1 X 3) X 0.8) +
3
2
+ (2 X (2 X 3) X 0.84) )(1/2)
((8000^2+(2 X 8000 X 7000 X 0.9)+7000^2+(2 X 8000 X 4000 X 0.8)+4000^2+(2 X 7000*4000 X 0.84)))
328040000
18,112
Ans2a- Existing Product Plus Pudding
Expected Net Present Value
Product Net Present Value
Ice Cream 16000
Cottage Cheese 20000
Yogurt 10000
Pudding 12000
58000
Standard Deviation
Standard deviation =

( (
1
2
+ (2 X (1 X 2) X 0.9) +
2
2

+ (2 X (1 X 3) X 0.8) +
3
2
+ (2 X (2 X 3) X 0.84) +
( (
4
2
+ (2 X (1 X 4) X 0.4) + (2 X (2 X 4) X 0.2) + (2 X (3 X 4) X 0.3) )(1/2))
((8000^2+(2 X 8000 X 7000 X 0.9)+7000^2+(2 X 8000 X 4000 X 0.8)+4000^2+(2 X 7000*4000 X 0.84)))
+((9000^2+(2 X 8000 X 9000 X 0.4)+(2 X 7000 X 9000 X 0.2)+(2 X 4000 X 9000 X 0.3)))
513440000
22,659
Zell Company would like a new product line- Puddings. The expected value of standard deviation
of the probability distribution of of possible net present value for the product line are $12,000 and 9,000
respectively. The company existing lines are, ice cream, cottage cheese and yogurt. The expected value
Puddings
1.00
a- Compute the expected value and standard deviation of the probability distribution of the possible
b- Compute the expected value and standard deviation for a combination consisting of existing product
plus Puddings. Compare your results in part a and b. What can you say about the pudding line.
( (
1
2
+ (2 X (1 X 2) X 0.9) +
2
2

+ (2 X (1 X 3) X 0.8) +
3
2
+ (2 X (2 X 3) X 0.84) )(1/2)
((8000^2+(2 X 8000 X 7000 X 0.9)+7000^2+(2 X 8000 X 4000 X 0.8)+4000^2+(2 X 7000*4000 X 0.84)))
((8000^2+(2 X 8000 X 7000 X 0.9)+7000^2+(2 X 8000 X 4000 X 0.8)+4000^2+(2 X 7000*4000 X 0.84)))
+((9000^2+(2 X 8000 X 9000 X 0.4)+(2 X 7000 X 9000 X 0.2)+(2 X 4000 X 9000 X 0.3)))
Q3-
Feldstein Drug Company is considering a new drug, which would be sold over the counter
without a prescription. To develop the drug and to market it on regional basis will cost $12
million over the next 2 years. $6 million in each year. Expected cash flows associated with
the project for years 3 through 8 are $1 million, $2 million, $4 million, $4 million, $3 million,
and $1 million, respectively. If the product is not successful at the end of year 5, the company
has an option to invest additional $10 million and there will be no expected incremental
cash flows. If successful, however, cash flows are expected to $6 million higher in each of the
years 6through 10 than would otherwise be the case with a probability of .5 and $4 million
higher with a probability of .5. the company's required rate of return for the project is 14 percent.
a- What is the net present value of the project if it is acceptable?
b- What is the worth of the project if we take account of the option to expand? Is the project acceptable
Success Success Failure
Ans3- 50% of 60% chance 50% of 60% chance 50% of 40% chance
Year Cash Flow DF 14% PV Add Inv PV Add Inv PV
1 6,000,000 - 0.877 5,263,158 -
2 6,000,000 - 0.769 4,616,805 -
3 1,000,000 0.675 674,972
4 2,000,000 0.592 1,184,161
5 4,000,000 0.519 2,077,475 10,000,000 - 5,193,687 - 10,000,000 - 5,193,687 -
6 4,000,000 0.456 1,822,346 6,000,000 2,733,519 4,000,000 1,822,346
7 3,000,000 0.400 1,198,912 6,000,000 2,397,824 4,000,000 1,598,549
8 1,000,000 0.351 350,559 6,000,000 2,103,354 4,000,000 1,402,236
9 0.308 6,000,000 1,845,048 4,000,000 1,230,032
10 0.270 6,000,000 1,618,463 4,000,000 1,078,975
Worth of the project NPV 2,571,539 - 5,504,521 1,938,452 -
0.3 0.3 0.4
1,651,356 581,536 -
2,571,539 - Worth of the option (NPV) 2,232,892
Worth of the project with option 338,647 -
Conclusion: While the option's value raises the worth of the project, it does not entirely set off the initial project's negative NPV.
Therefore, we still would rejected the project.
Prob1-
The probability distribution of the possible net present values for project X has an
expected value of $20,000 and a standard deviation of $10,000. Assuming a normal
distribution, calculate the probability that the net present value will be zero or less,
that it will be greater than $30,000; and that it will be less than $5,000.
Ans1-
Probability of NPV = X - NPV

Zero or Less = 0 - 20000 -20,000 -2.0

10,000 10,000
30,000 or more = 30000 -20000 10,000 1.0
10,000 10,000
5,000 or more = 5000 - 20000 -15,000 -1.5
10,000 10,000
From Table C, these standardized differences corresponds to the probabilities of 0.228, 0.1577,
and 0.668 respectively.
Prob2-
The Dewitt Corporation has determined the following decrease probability distributions
for the net cash flows generated by a contemplated project.
Probability Cash Flows Probability Cash Flows Probability
Cash
Flows
0.10 1,000 0.20 1,000 0.30 1,000
0.20 2,000 0.30 2,000 0.40 2,000
0.30 3,000 0.40 3,000 0.20 3,000
0.40 4,000 0.10 4,000 0.10 4,000
a- Assume that probability distribution of cash flows for future periods are independent.
Also, assume that risk-free rate is 7 percent. If the initial outlay of $5,000, determine the
mean net present value.
b- Determine the standard deviation about the mean.
c- if total distribution is approximately normal and assumed continuous, what is the
probability that the net present value being zero or less?
d- What is the probability that net present value will be greater than zero?
e- What is the probability that the profitability index will be 1.00 or less?
f- What is the probability that the profitability will be greater than 2.00?
Ans2a- Calculation of NPV
Probability Cash Flows Exp. Val
0.10 1,000 100.00
0.20 2,000 400.00
0.30 3,000 900.00
0.40 4,000 1,600.00
3,000.00
Probability Cash Flows Exp. Val
0.20 1,000 200.00
0.30 2,000 600.00
0.40 3,000 1,200.00
0.10 4,000 400.00
2,400.00
Probability Cash Flows Exp. Val
0.30 1,000 300.00
0.40 2,000 800.00
0.20 3,000 600.00
0.10 4,000 400.00
2,100.00
Period Cash Flows DF PV
0 5,000 - 1.00 5,000 -
1 3,000 0.93 2,804
2 2,400 0.87 2,096
3 2,100 0.82 1,714
NPV 1,614
Period 1
Period 2
Period 1 Period 2 Period 3
Period 3
Ans2b-
Calculation of Standard Deviation
Since, the Cash flows over the period are independent and not dependent, formula for calculating
the standard deviation would be different and would be as follows:
=
Probability Cash Flows CF - Mean Sq(CF - Mean) Sq(CF - Mean) X Prob
0.10 1,000 2,000.00 - 4,000,000.00 400,000.00
0.20 2,000 1,000.00 - 1,000,000.00 200,000.00
0.30 3,000 - - -
0.40 4,000 1,000.00 1,000,000.00 400,000.00
1,000,000.00
1000
Probability Cash Flows CF - Mean Sq(CF - Mean) Sq(CF - Mean) X Prob
0.20 1,000 1,400.00 - 1,960,000.00 392,000.00
0.30 2,000 400.00 - 160,000.00 48,000.00
0.40 3,000 600.00 360,000.00 144,000.00
0.10 4,000 1,600.00 2,560,000.00 256,000.00
840,000.00
917
Probability Cash Flows CF - Mean Sq(CF - Mean) Sq(CF - Mean) X Prob
0.30 1,000 1,100.00 - 1,210,000.00 363,000.00
0.40 2,000 100.00 - 10,000.00 4,000.00
0.20 3,000 900.00 810,000.00 162,000.00
0.10 4,000 1,900.00 3,610,000.00 361,000.00
890,000.00
943
Sum of 1000^2 917^2 943^2
(1.07)^(1 X 2) (1.07)^(2 X 2) (1.07)^(2 X 3)
= 1000000 840889 889249
1.1449 1.31079601 1.500730352
= 873,439 641,510 592,544
= 2,107,493
= 1452
Period 2
Period 3
Period 1
Ans2c- Probability of NPV Zero or Less
Probability of NPV = X Value

Zero or Less = 0 - 1614

1,452
1,614
1,452
Standard Deviation = 1.1
Probability = 0.134
Ans2d- Probability of NPV greater than Zero
= 1 - Probability of NPV Zero or Less
= 1- 0.134
0.866
Ans2e- The probability that the profitability index will be 1.00 or less
Profitability index is 1 when NPV is Zero, thus, the probability that the
profitability index is 1 is 0.134
Ans2e- The probability that the profitability will be greater than 2.00
If Profitability Index is 2, then NPV is 0 + 5,000 = 5,000
Therefore,
NPV = 5000 - 1614
1,452
3,386
1,452
Standard Deviation 2.3
Probability 0.01 or 1 Percent
Prob3-
Ponape Lumber Company is evaluating a new saw with a life of 2 years. The saw
costs $3,000 and future after tax cash flows depend on the demand for the company's
product. The probability tree of possible future cash flows associated with the new saw is:
Initial
Probability Cash Flows
Conditional
probability
Initial
Probability Cash Flows Branch
0.3 1000 1
0.4 1500 0.4 1500 2
0.3 2000 3
0.4 2000 4
0.6 2500 0.4 2500 5
0.2 3000 6
a- What are the joint probabilities of occurrence of various branches?
b- if the risk-free rate is 10 percent, what are the mean and standard deviation of the probability
distribution possible net present values?
c- Assuming a normal distribution, What is the probability that the actual net present value will be
zero or less?
Ans3a-
Initial
Probability Cash Flows
Conditional
probability Cash Flows Branch
0.3 1000 1
0.4 1500 0.4 1500 2
0.3 2000 3
0.4 2000 4
0.6 2500 0.4 2500 5
0.2 3000 6
Mean NPV
Year 0 1 2
DF 10% 1.000 0.909 0.826
Branch NPV Con. Prob
1 3,000 - 1,364 826 810 - 0.12
2 3,000 - 1,364 1,240 397 - 0.16
3 3,000 - 1,364 1,653 17 0.12
4 3,000 - 2,273 1,653 926 0.24
5 3,000 - 2,273 2,066 1,339 0.24
6 3,000 - 2,273 2,479 1,752 0.12
Mean NPV
Year 1 Year 2
Year 1 Year 2
Years
Standard Deviation
A B C = (A -B) D = C
2
E F = D X E
Branch Net C.F Mean NPV Con. Prob
1 810 - 595 1,405 - 1,973,909 0.12 236,869
2 397 - 595 992 - 983,539 0.16 157,366
3 17 595 579 - 334,677 0.12 40,161
4 926 595 331 109,282 0.24 26,228
5 1,339 595 744 553,241 0.24 132,778
6 1,752 595 1,157 1,338,706 0.12 160,645
754,047
Square Root 868
Ans3a-
The probability of NPV zero or less = 0 - NPV

0 - 595
868
-595
868
-0.6854839
After checking from table C, we find -0.68548 falls between .65 and .70
These standard deviation correspond to areas under the curve of .2578 & .2420, respectively
Where,
0.68548 = Standardized deviation
0.65 = Lower Standard Deviation
0.7 = Higher Standard Deviation
0.2578 = Area of the lower standard deviation
0.242 = Area of the higher standard deviation
Applying interpolation method, we have
.2578 - (.2578-.2420) X ((.68548 - .65) / (.7 - .65))
0.246588 X 100 24.66%
Conclusion: Thus, there is approximately 25 percent probability that actual return will be zero or less
Joint
Probabilities
0.12
0.16
0.12
0.24
0.24
0.12
Mean NPV
97 -
63 -
2
222
321
210
595
Prob4-
Xonic Graphic is evaluating a new technology for its reproduction equipment. The technology will have a 3-year life
and cost $1,000. its impact on cash flows is subject to risk. Management estimates that there is 50-50 chance that
technology will either save the company $1,000 in the first year or save it nothing at all. if nothing at all, savings
in the last 2 years would be zero. Even worse, in the second year, an additional outlay of $300 may be required
to convert back to original process, for the new technology may result in less efficiency. Management attaches a
40 percent probability to this occurrence, given the fact that new technology "bombs out" in the first year.
If the technology proves it self, the second-year cash flows may be either $1,800, $1,400 or $1,000 with probabilities
of 0.2, 0.6 and 0.2, respectively. In the third-year cash flows are expected to be $200 greater or $200 less than the
cash flows in the period 2, with an equal chance of occurrence. (Again these cash flows depend on the cash flows
in the period 1 being $1,000). All cash flows are after tax.
a- set up a probability tree to depict the foregoing cash flow probabilities.
b- Calculate a net present value for each three-year possibility, using a risk-free rate
of 5 percent.
c- What is the risk of the project?
Ans4a- Requirement A
DF 1 0.952 0.907 0.864
Cash Flow Cond. Prob Cash Flow Cond. Prob Cash Flow Cond. Prob Cash Flow Cond. Prob Cash Flow Joint Prob. NPV Exp. Val
0.5 0 0.4 -300 1.0 0 0.2 1,272 - 254 -
0.6 0 1.0 0 0.3 1,000 - 300 -
-1000 -1000
0.5 800 0.05 1,550 78
0.2 1000
0.5 1200 0.05 1,896 95
0.5 1000 0.5 1200 0.15 2,259 339
0.6 1400
0.5 1600 0.15 2,604 391
0.5 1600 0.05 2,967 148
0.2 1800
0.5 2000 0.05 3,313 166
661
Overall
Requirement B
Period 1 Period 2 Period 0 Period 3
Ans4c- Risk of the project =
Joint Prob. NPV Mean NPV (NPV -Mean NPV)^2 X Prob
0.20 (1,272) 661 747,672
0.30 (1,000) 661 828,051
0.05 1,550 661 39,525
0.05 1,896 661 76,217
0.15 2,259 661 382,778
0.15 2,604 661 566,280
0.05 2,967 661 265,835
0.05 3,313 661 351,478
3,257,837
Square Root 1805
Conclusion: Thus, the distribution of possible probability distribution of possible net
present values is very wide. In turn, this is due to a 50 percent probability of zero outcome or less.
Prob5-
The Hume Corporation is faced with several possible investment projects. For each, the total
cash out flow required will occur in the initial period. The cash outflow, expected net present
values, and standard deviations are as follows:
( All projects are discounted at risk-free rate of 8 percent, and it is assumed that distribution
of their possible net present values are normal.)
Project Cost Net Present Value
A 100,000 10,000 20,000
B 50,000 10,000 30,000
C 200,000 25,000 10,000
D 10,000 5,000 10,000
E 500,000 75,000 75,000
a- Determine the coefficient of variations for each of these projects. (use cost plus net present
value in the denominator of the coefficient.)
b- Ignoring sizes, do you find some projects clearly dominated by others?
c- May size be ignored?
d- What is the probability that each of these projects will have a net present value greater than 0 ?
e- What decision rule would you suggest for adoption of projects within this context? Which (if any)
of the forgoing projects would be adopted under your rule?
Ans5a- Coefficient of Variations
Project Cost Plus NPV Co of Var.
A 110,000 20,000 0.18
B 60,000 30,000 0.50
C 225,000 10,000 0.04
D 15,000 10,000 0.67
E 575,000 75,000 0.13
Ans5b- Domination of one project by other(s)
A project is dominated by the other if its Cov. of Var. is
greater than that of other.
Project A Dominated by project E & C
Project B Dominated by project A, C, and E
Project C Dominated by None of the others.
Project D Dominated by all the projects
Project E Dominated by Project C
Ans5c- Size of the project
Size can not be ignored in a Realistic System
Ans5d- Probability of Project greater than zero
Project NPV/ Prob of Zero Prob > 0
A 0.50 0.3085 0.692
B 0.33 0.37 0.630
C 2.50 0.0062 0.994
D 0.50 0.3085 0.692
E 1.00 0.1577 0.842
Ans5e- Decision rule suggestion for adoption of projects
Although most people would prefer project C. However,
No solution may be recommended.
Prob6-
The Windop Company will invest in two of three possible proposals, the cash flows of
which are normally distributed. The expected net present value (discounted at risk
free rate) and the standard deviation of each proposal are given as follows:
Proposals 1 2 3
Expected net present value 10000 8000 6000
Standard deviation 4000 3000 4000
Assume the following correlation coefficients for each possible combination, which two
proposals dominate?
Proposals 1 2 3 1 and 2 1 and 3
Correlation Coefficient 1.0 1.0 1.0 0.6 0.4
Expected net present value NPV
Ans6- Proposal 1 & 2 10000 8000 18000
Proposal 1 & 3 10000 6000 16000
Proposal 2 & 3 8000 6000 14000
Standard deviation = (
1
^
2
+ (2 X (
1
X
2
) X 0.6) +
2
^
2
)^
(1/2)
Proposal 1 & 2 = (4000^
2
+ (2 X (4000 X 3000) X 0.6) + 3000^
2
)^
(1/2)
= 6277
Proposal 1 & 3 = (4000^
2
+ (2 X (4000 X 4000) X 0.4) + 4000^
2
)^
(1/2)
= 6693
Proposal 2 & 3 = (3000^
2
+ (2 X (3000 X 4000) X 0.7) + 4000^
2
)^
(1/2)
= 6465
NPV SD
Project-1 18,000 6,277
Project-2 16,000 6,693
Project-3 14,000 6,465
Conclusion: Proposal 1 & 2 have both highest NPV and lowest standard deviation, therefore,
these dominate in all other proposals' combination
2 and 3
0.7
Prob8-
The Ferret Company is considering a new location. If it constructs an office
and 100 cages, the cost will be $100,000 and the project is likely to produce
net cash flows of $17,000 per year for 15 years, after which the leasehold on
land expires and there will be no residual value. The company's required
rate of return is 18 percent. If the location proves favorable, Ferret pet will
be able to expand by 100 cages at the end of 4 years. The cost per cage would
be $200 With the new cages, incremental cash flows of $17,000 per year
for years 5 through 15 would be expected. The company believes there is a 50-50
chance that the location will prove to be a favorable one.
a- if the initial project favorable?
b- What is the value of the option? The worth of the project with the option?
Is it acceptable?
First Approach Second Approach
Ans8a- Ans8a-
Year Cash Flows DF 18% PV Year Cash Flows DF 18% PV
0 -100000 1.000 100,000 - 0 -100000 1.000 100,000 -
1 17000 0.847 14,407 1 - 15. 17000 5.092 86,557
2 17000 0.718 12,209
3 17000 0.609 10,347 NPV 13,443 - 1
4 17000 0.516 8,768
5 17000 0.437 7,431 Conclusion: Initially project is unacceptable since, NPV is negative
6 17000 0.370 6,297
7 17000 0.314 5,337 Ans8b-
8 17000 0.266 4,523 Option Valuation:
9 17000 0.225 3,833
10 17000 0.191 3,248 Year Cash Flows DF 18% PV
11 17000 0.162 2,753 4 -20000 0.516 10,316 -
12 17000 0.137 2,333 5 - 15 17000 2.402 40,826
13 17000 0.116 1,977
14 17000 0.099 1,675 NPV 30,510 0.5
15 17000 0.084 1,420 The Worth of the project with the Option:
NPV 13,443 - NPV X 0.5 + NPV X 0.5
13,443 - + 30,510 X 0.5
1,812
Conclusion: The value of the option enhances the worth of the
project and make it acceptable
Prob10-
ABC Corporation is ordering a special purpose piece of machinery costing $9,000
with a useful life of 2 years, after which there is no expected salvage value.
The possible incremental net cash flows are:
Cash
Flow Probability Cash Flow
Conditional
Probability
2,000 0.3
6,000 0.3 3,000 0.5
4,000 0.2
4,000 0.3
7,000 0.4 5,000 0.4
6,000 0.3
6,000 0.2
8,000 0.3 7,000 0.5
8,000 0.3
The companys required rate of investment for this project is 8 percent.
a- Calculate the mean of the probability distribution of the possible net present values.
b- Suppose now that the possibility of abandonment exists and that the abandonment
value of the project at the end of year 1 is $4,500. Calculate the new mean NPV, assuming
the company abandons the project if it is worth while to do so. Compare your calculations
with those in part a. What are the implications.
Ans10a-
Year 1 Year 2
Cash
Flow Probability Cash Flow
Conditional
Probability
Joint
probabilities
2,000 0.3 0.09
6,000 0.3 3,000 0.5 0.15
4,000 0.2 0.06
4,000 0.3 0.12
7,000 0.4 5,000 0.4 0.16
6,000 0.3 0.12
6,000 0.2 0.06
8,000 0.3 7,000 0.5 0.15
8,000 0.3 0.09
1.00
Year 1 Year 2
0 1 2
DF 1.000 0.926 0.857
Net C.F Mean NPV
Branch 1 9,000 - 6,000 2,000
9,000 - 5,556 1,715 1,730 - 0.09 155.68 -
2 9,000 - 6,000 3,000
9,000 - 5,556 2,572 872 - 0.15 130.86 -
3 9,000 - 6,000 4,000
9,000 - 5,556 3,429 15 - 0.06 0.91 -
4 9,000 - 7,000 4,000
9,000 - 6,481 3,429 911 0.12 109.30
5 9,000 - 7,000 5,000
9,000 - 6,481 4,287 1,768 0.16 282.91
6 9,000 - 7,000 6,000
9,000 - 6,481 5,144.0 2,626 0.12 315.06
7 9,000 - 8,000 6,000
9,000 - 7,407 5,144 3,551 0.06 213.09
8 9,000 - 8,000 7,000
9,000 - 7,407 6,001 4,409 0.15 661.32
9 9,000 - 8,000 8,000
9,000 - 7,407 6,859 5,266 0.09 473.95
Mean Net Present Value 1.00 1768
Ans10b-
Project worth = NPV without abandonment option + Value of abandonment Option
The value of the project at the end of year 1 is $4,500.00 0.926 $4,167
DF 1.000 0.926 0.857
Branch 1 9,000 - 10,500
9,000 - 9,722 - 722 0.30 216.67
2
- - - - 0.15 -
3
- - - - 0.06 -
Year
4 9,000 - 7,000 4,000
9,000 - 6,481 3,429 911 0.12 109.30
5 9,000 - 7,000 5,000
9,000 - 6,481 4,287 1,768 0.16 282.91
6 9,000 - 7,000 6,000
9,000 - 6,481 5,144.0 2,626 0.12 315.06
7 9,000 - 8,000 6,000
9,000 - 7,407 5,144 3,551 0.06 213.09
8 9,000 - 8,000 7,000
9,000 - 7,407 6,001 4,409 0.15 661.32
9 9,000 - 8,000 8,000
9,000 - 7,407 6,859 5,266 0.09 473.95
Mean Net Present Value 2272
Conclusion: The present value of the abandonment value at the end of year 1 is $4,167.
Therefore, the project would be abandoned if the period 1 cash flows turned out to be
$6,000. ( The mean of present value for period 2 is lower than the abandonment value.)
It would not be worthwhile to abandon the project if either of the other year outcomes
occurred.
The present value of cash flows are the same as in part a's solution except for the main
branch which has a mean NPV of $723.
Thus, the mean net present value is increased when the probability of abandonment is
considered in the evaluation.
Prob10-
ABC Corporation is ordering a special purpose piece of machinery costing $9,000
with a useful life of 2 years, after which there is no expected salvage value.
The possible incremental net cash flows are:
Cash Flow Probability Cash Flow
Conditional
Probability
2,000 0.3
6,000 0.3 3,000 0.5
4,000 0.2
4,000 0.3
7,000 0.4 5,000 0.4
6,000 0.3
6,000 0.2
8,000 0.3 7,000 0.5
8,000 0.3
The companys required rate of investment for this project is 8 percent.
a- Calculate the mean of the probability distribution of the possible net present values.
b- Suppose now that the possibility of abandonment exists and that the abandonment
value of the project at the end of year 1 is $4,500. Calculate the new mean NPV, assuming
the company abandons the project if it is worth while to do so. Compare your calculations
with those in part a. What are the implications.
Ans10a-
Year 1 Year 2
Cash Flow Probability Cash Flow
Conditional
Probability
Joint
probabilities
2,000 0.3 0.09
6,000 0.3 3,000 0.5 0.15
4,000 0.2 0.06
4,000 0.3 0.12
7,000 0.4 5,000 0.4 0.16
6,000 0.3 0.12
6,000 0.2 0.06
8,000 0.3 7,000 0.5 0.15
8,000 0.3 0.09
1.00
Year DF 1 2 3 4
Year 1 Year 2
Branches
0 1.000 9,000 - 9,000 - 9,000 - 9,000 -
1 0.926 6,000 6,000 6,000 7,000
2 0.857 2,000 3,000 4,000 4,000
NPV 1,730 - 872 - 15 - 911
Joint Prob. 0 0.15 0.06 0.12
Mean NPV 156 - 131 - 1 - 109
Ans10b-
Project worth = NPV without abandonment option + Value of abandonment Option
Year DF 1 2 3 4
0 1.000 9,000 - 9,000 -
1 0.926 10,500 7,000
2 0.857 4,000
NPV 722 - - 911
Joint Prob. 0.3 0.12
Mean NPV 217 - - 109
$4,500.00 0.926 $4,167
Conclusion: The present value of the abandonment value at the end of year 1 is $4,167.
Therefore, the project would be abandoned if the period 1 cash flows turned out to be
$6,000. ( The mean of present value for period 2 is lower than the abandonment value.)
It would not be worthwhile to abandon the project if either of the other year outcomes
occurred.
The present value of cash flows are the same as in part a's solution except for the main
branch which has a mean NPV of $723.
Thus, the mean net present value is increased when the probability of abandonment is
considered in the evaluation.
Branches
a- Calculate the mean of the probability distribution of the possible net present values.
b- Suppose now that the possibility of abandonment exists and that the abandonment
value of the project at the end of year 1 is $4,500. Calculate the new mean NPV, assuming
the company abandons the project if it is worth while to do so. Compare your calculations
5
Branches
9,000 -
7,000
5,000
1,768
0.16
283
Project worth = NPV without abandonment option + Value of abandonment Option
5
9,000 -
7,000
5,000
1,768
0.16
283
Conclusion: The present value of the abandonment value at the end of year 1 is $4,167.
Therefore, the project would be abandoned if the period 1 cash flows turned out to be
$6,000. ( The mean of present value for period 2 is lower than the abandonment value.)
It would not be worthwhile to abandon the project if either of the other year outcomes
The present value of cash flows are the same as in part a's solution except for the main
Thus, the mean net present value is increased when the probability of abandonment is
Branches