Sol. For Case Study 2012 Calculation relating to initial project: Year CF PVIF at 14% PV at 14% 1 -6 0.877 -5.

262 2 -6 0.769 -4.614 3 1 0.675 0.675 4 2 0.592 1.184 5 4 0.519 2.076 6 4 0.456 1.824 7 3 0.4 1.200 8 1 0.351 0.351 NPV -2.566 Since the NPV of the initial project is negative, it is not acceptable. If the project is successful at the end of year 5, expected value of incremental future cash flows at the end of year 5: = [ -10 + 6X PVIFA (14%, 5 years) ]x [ -10 + 4x PVIFA (14%, 5 years) ]x = [ -10 + 6x 3.433 ] x 0.5 [ -10 + 4x 3.433 ] x 0.5 = 5.299 + 1.866 = 7.165 If the project is not successful at the end of year 5, expected value of incremental future cash flows at the end of year 5 would be zero. Value of the option = Value of the option = 7.165 x 4.299 0.6 + 0x

NPV of the project if the option to expand is taken into consideration = NPV of the initial project + Discounted value of the value of the option to expand = -2.566 + 4.299 x PVIF (14%, Year 5) = -2.566 + 4.299 x 0.519 = -2.566 + 2.231 = Rs. -0.335 million Since the NPV of the project is negative even after taking the option to expand in consideration, the project is not acceptable.

Prob-6 2012 This problem is incomplete. Thanks to the negligence of the paper setter, some of the data are missing. The complete problem r The scientists at spectrum have come up with an electric moped. The firm is ready for pilot production and test marketing. This will cost Rs. 20 million and take six months. Management believes that there is 70% chance that pilot production and test marketing will be successful. In case of success, spectrum can build a plant costing Rs. 150 million. The plant will generate annual cash flow of Rs. 30 million for 20 years if the demand is high or an annual cash flow of Rs. 20 million if the demand is low. High demand has a probability of 0.6; low demand has probability of 0.4. Assume a discount rate of 12%. Suggest the optimal course of action using decision tree analysis.

C21: High demand 0.6 D21: Invest: C2

-150 D11: Carry out pilot production and market test: C1 -20 D1 C11: Success: D2 0.7 D22: Stop C12: Failure Stop 0.3 C22:Low demand 0.4

D12: Do nothing We should start from the right hand end of the tree and calculate the NPV at chance point C2 that comes first as we proceed leftw NPV(C2) = 0.6 X 30 X PVIFA(12%, 20 years) 0.4 X 20 X PVIFA(12%, 20 years) = 134.4498 + 59.7556 = 194.2054 NPV of decision alternatives at D2: Alternatives NPV D21 44.2054 D22 0 D21 is selected and D22 is cancelled as NPV (D21)> NPV(D22) NPV(C1) = 0.7 x 44.2054 + NPV(C1) = 30.94378 NPV of decision alternatives at D1: Alternatives NPV D11 10.94378 D12 0 Based on the above evaluation, the optimal decision strategy is as follows: Choose D11 (carry out pilot production and market test) at decision point D1 and wait for the outcome at the chance point C1. If the outcome is C11 ( success), invest 150 million. If the outcome at C1 is C12 (failure), stop. Note: D stands for decision point and C stands for chance point.

0.3 x

flows at the end of year 5: 0.5 + 0.5 +

ash flows at the end of year 5

0.4

ation, the project is not acceptable.

ta are missing. The complete problem reads as follows:

t production and test re is 70% chance that ld a plant costing Rs. mand is high or an

n using decision tree analysis.

C21: High demand

30

C22:Low demand

20

C2 that comes first as we proceed leftwards: +