Capital Budgeting contd.

Prof. Prapti Paul

Question on Decision Tree Approach in Capital Budgeting

A firm has an investment proposal, requiring an outlay of Rs.40,000. the investment proposal is expected to have 2 years economic life with no salvage value. In year 1, there is 0.4 probability that the cash inflow after tax will be Rs.25,000 and 0.6 probability that the cash inflow after tax will be Rs.30,000. the probabilities assigned to cash inflows after tax for the year 2 are as follows: Cash inflow in year 1: Rs. 25000 Rs.30000 Cash inflow in year 2: Probability Probability Rs. 12000 0.2 Rs. 25000 0.4 Rs.16000 0.3 Rs.25000 0.5 Rs.22000 0.5 Rs.30000 0.1 The firm uses a 10% discount rate for this type of investment. Required: a) Construct a decision tree for the proposed investment project b) What NPV will the project yield if worst outcome is realized? What is the probability of occurrence of this NPV? c) What will be the best outcome and the probability of that occurrence? d) Will the project be accepted?

Solution :
a) The decision tree: Rs.12000

Path No.

Joint probabili ty yr1*yr2 0.08 0.12 0.20

1 2 3

Rs.25000

Rs.16000
Rs.25000

Cash outlay Rs.40,000 Rs.20000 Rs.30000 Rs.25000 Rs.30000 4 5 6 0.24 0.30 0.06 1.00

The decision tree shows that there are six possible outcomes each represented by a path. The NPV of each path at 10% discount rate is given below:
Path (Cash Inflow yr1*disc factor yr1) (a) (Cash inflow yr2*discount factor yr2) (b)
Rs.12000*0.826=9912

Total cash inflow (c )=(a)+(b)

Cash outflow (d)

NPV (e) = (c )-(d)

Rs.25,000*0.909=22725

Rs.32637

Rs.40000

Rs.-7363

2
3 4 5 6

Rs.25000*0.909 =22725
Rs.25000*0.909 =22725 30000*0.909=27270 30000*0.909=27270 30000*0.909=27270

16000*0.826= 13216
22000*0.826=18172 20000*0.826=16520 25000*0.826=20650 30000*0.826=24780

35941
40897 43790 47920 52050

40000
40000 40000 40000 40000

-4059
897 3790 7920 12050

Statement showing the expected NPV: Path 1 2 3 4 5 6 NPV @10% (A) Rs. -7363 -4059 897 3790 7920 12050 Joint Probability (B) .08 .12 .20 .24 .30 0.06 Expected PV (A)*(B) Rs.-589.04 -487.08 179.40 909.60 2376.00 723.00

1.00

3,111.88

b) If the worst outcome is realized, the NPV which the project will yield is Rs.7363 (negative). The probability of occurrence of this NPV is 8%. c) The best outcome will be path 6 when NPV is highest i.e. Rs.12050 (positive). The probability of occurrence of this NPV is 6% d) Yes, the project will be accepted since the Expected NPV is positive.