Page 199 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 9: Capital Budgeting

3. Specification of probabilities and monetary outcome Notes
4. Evaluation of various decision alternatives

Example: A firm has an investment proposal, requiring an outlay of 40,000. The
investment proposed is expected to have 2 years’ economic life with no salvage value. In year I,
there is a 0.4 probability that cash inflow after tax will be 25000 and 0.6 probability that cash
inflow after tax will be 30,000. The probabilities assigned to cash inflows after tax for the year
II are as follows:

The cash inflow year I 25,000 30,000
The cash inflow year II 12000 Probability 0.2 20,000 Probability 0.4
16,000 Probability 0.3 25,000 Probability 0.5
22,000 Probability 0.5 30,000 Probability 0.1
The firm uses a 10% discount rate for this type of investment.

Required:
1. Construct a decision-tree for the proposed investment project.
2. What net present value will the project yield if worst outcome is realized? What is the
probability of occurrence of this NPV?
3. What will be the best and probability of that occurrence?
4. Will the project be accepted? 10%, Discount factor 1 year 0.909

2 year 0.826
Solution:
Year Cash Year Cash Path Expected Joint Expected
1 (nflow 2 Inflow no NPV at prob NPV x
prob (- ) prob. ( ) 10% rate (prob Joint
of year1x Prob.
discount prob.
Year 2)
0.2 12,000 1 -7363 0.08 -589
Investment
proposal, 0.4 25,000 0.3 16,000 2 -4059 0.12 -487
capital Outlay 0.5 22,000 3 897 0.20 179
40000
0.4 20,000 4 3,790 0.24 910
0.6 30,000 0.5 25,000 5 7,920 0.30 2,375
0.1 30,000 6 12,050 0.06 723
3112

Expected NPV:
Cash × Discount + Cash × Discount – Cash
Inflow Factor inflow Factor Outlay
Year 1 Year 2
Path 1 = 25000 × 0.909 + 12000 × 0.826 – 40000 = 32637 – 40000 = – 7363
2 = 25000 × 0.909 + 16000 × 0.826 – 40000 = 35941 – 40000 = – 4059
3 = 25000 × 0.909 + 22000 × 0.826 – 40000 = 40897 – 40000 = 897

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