Calculate the expected npv and coefficient of variation

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Reference no: EM133344283

Case Study: Acme Auto Parts is contemplating developing a new transmission. Development costs are high and the chances of failure at the different stages of the project are significant. To accurately estimate the NPV and reduce risk, Acme has decided to incorporate management options using decision trees.

Initially, Acme plans to spend CAD 500,000 for basic designs. It believes there is a 60% chance these plans will be successful. If the basic designs fail, the company thinks it can get back part of the expense by selling its ideas to a foreign manufacturer for CAD 125,000.

The next stage, at the end of Year 1, involves developing five prototypes for CAD 95,000 each. Once developed, the prototypes will be thoroughly tested, and the company expects there is a 50% chance that these tests will be successful. If unsuccessful, the prototypes and specially purchased production equipment can be sold for CAD 150,000.

At the end of Year 2, a new production line will be built for CAD 5,000,000. If demand is strong, net cash flows will be CAD 3,500,000 a year for 4 years. There is a 60% chance this will occur. If demand is moderate, net cash flows will be CAD 2,000,000 a year for 2 years and there is a 20% chance of this happening. Finally, if the product is a failure, net cash flows will only be CAD 1,000,000 a year for one year.

If the production equipment is only used for one or two years, it could be sold for CAD 3,000,000. If demand is high, management can expand the production line for CAD 1,000,000 in Year 3 to increase net cash flows to CAD 4,500,000 in Years 4, 5, and 6.

Acme's RRR is 12.0%. Inflation is expected to be negligible and all cash flows are after-tax.

Questions:

Calculate the expected NPV and coefficient of variation of this capital project.

What are the different types of management options being used?

Reference no: EM133344283

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