Reference no: EM132816116

Instructions: This question is COMPULSORY. Show your workings clearly.

Decision Tree

Advance Technologies is considering the production of an optical laser device for the medical industry. The firm decides to pursue the project that will require $500,000 on a marketing study. Management estimates that there is a 0.8 probability that the study will produce favorable results, leading to the decision to move on with the project. However, if the marketing study produces negative results, the project will be canceled at that point. If the marketing study yields positive results, then Advance Technologies will spend $1,000,000 to develop a prototype. Management estimates (before even making the initial $500,000 investment) that there is a 60 percent probability that the medical associations will find the device useful and a 40 percent probability that they will not like it. If the doctors like the device, the firm will spend the final $10,000,000 to build the plant and go into production. If the doctors do not like the prototype, the project will be dropped. If the firm does go into production, the operating cash flow over the next 3 years will depend on how well the market accepts the final product. There is a 30 percent chance that there will be high demand and net inflows will be $18 million per year, a 40 percent probability of medium demand generating inflows of $8 million each year, and a 30 percent chance of low demand creating negative cash flows of $2 million. If demand is low, the firm will terminate the project and avoid losses beyond the first year.

Produce a decision tree to reflect the financial decisions of Advance Technologies.

What is the project's expected Net Present Value?