Reference no: EM132767535

Work Station Inc. manufactures office furniture. The firm is interested in "ergonomic" products that are designed to be easier on the bodies of office workers who suffer from ailments such as back and neck pain due to sitting for long periods. Unfortunately, customer acceptance of ergonomic furniture tends to unpredictable, so a wide range of market response is possible. Management has made the following two-year probabilistic estimate of the cash flows associated with the project arranged in decision tree format ($000).

($6000)---------0.6---------$4000---------0.3---------$7000
($6000)---------0.6---------$4000---------0.7---------$5000
($6000)---------0.4---------$2000---------0.8---------$3000
($6000)---------0.4---------$2000---------0.2---------$2400

Work Station is a relatively small company and would be seriously damaged by any project that lost more than $1.5 million. The firm's cost of capital is 19%. Assume Work Station Inc. has an abandonment option at the end of the first year under which it will recover $5 million of the initial investment in year 2.

Problem 1: Develop a probability distribution for NPV based on the initial forecast. In other words, calculate the project's NPV along each path of the decision tree and the associated probability.