Reference no: EM132608915

Daewoo company is considering undertaking a new project. The initial cost of the project is $100,000 and the expected life is two years. Management estimates that there is 60 percent chance that the company will receive $70,000 cash flows in the first year and 40 percent chance that the firm will receive $30,000. The management expects that second year cash flows depend upon the first-year cash flows. The management felt that in the second year the cash flows will be $60,000, $70,000 and $80,000 with the probabilities of 0.30, 0.40 and 0.30 respectively, in case the first-year cash flows are $70,000. In the second case, the cash flows will be either $15,000 more or $10,000 less than the previous year cashflows with fifty-fifty percent chance of occurrence.

Instructions

i. Set up a tabular version of probability tree to depict the cash flow possibilities, initial, conditional and joint probabilities.

ii. Using a 10 percent risk free rate, calculate the net present value for each branch and the expected value of a net present value for a project.

iii. Determine the risk of a project.