Question

The cash flows of a two-year project when demand turns out to be “high” and when demand turns out to be “low” are presented below. The probability that demand will be “high” is 50% and the probability that demand will be “low” is 50%. The appropriate discount rate is 10%
	Cash flow if demand is "high"	Cash flow if demand is "low"
Year 0	-$200	-$200
Year 1	$200	$100
Year 2	$200	$100

Refer to Exhibit II. What is the expected NPV of the project? Round your final answer to the nearest dollar. $

If demand turns out to be “high,” suppose that the firm has the option to invest an additional $100 at the end of Year 1 to increase production capacity. Doing so would result in an annual cash flow of $400 (rather than $200) at the end of Year 2. What is the expected NPV of the project, after accounting for this expansion option? Round your final answer to the nearest dollar. $

Refer to your previous answers. What is the value for this expansion option?  Round your final answer to the nearest dollar. $

Answer 1

NPV Calculation:

year	High Demand($)	Present Value = Cashflow/(1+ discount rate)^n	Low Demand($)	Present Value
0	(200)	(200)	(200)	(200)
1	200	200/(1+10%)^1 = 181.8	100	100/(1+10%)^1=$90.9
2	200	200/(1+10%)^2=165.2	100	100/(1+10%)^2 = $82.6
	NPV	$181.8+$165.2- $200 = $147		$90.9+$82.6 - $200 =($26.5)

Expected NPV = High Demand NPV * Probability + Low Demand NPV *Probability

= 50%($147)+ 50%(-$26.5)

= $73.5 - $13.25

=$60.25

2)

Year	Investment	Cashflow	Present Value =Cashflow * Discount Rate
0	$200		($200)
1	$100	$200	($100)/(1+10%)^1 =($90.9)	$200/(1+10%)^1=$181.8
2		$400		$400/(1+10%)^2=$330.4
NPV	= Cash inflow - Cash outflow		($200)+$(90.9) + $181.8+$330.4 = $221.3

NPV without additional investment = $ 147

NPV with additional investment = $ 221.3