Reference no: EM133044405

Question - 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 0.25, 0.5 and 0.25, 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.

Required -

a) Set up a probability tree to depict the foregoing cash flow probabilities and compute expected NPV and risk for aforesaid data if risk free rate of return is 7%.

b) Discuss risk and real options in capital budgeting analysis with the help of other then text book example.