Kangaro Youth Sports Ltd. wishes to design a new sports bicycle. The company will have to invest Sh.100 million at the beginning of the first year for the design and model testing of the new bicycle.
The firm’s managers believe that there is an 80% probability that this phase will be successful and the project will continue.
If Phase 1 is not successful, the project will be abandoned with zero salvage value.
The next phase, if undertaken, would consist of making the molds and producing twenty prototype bicycles. This would cost Sh.400 million at the end of the first year. If this phase is successful, the firm would go into full scale production. If the phase is not successful, the molds and prototypes could be sold for Sh.150 million. The managers estimate that the probability that the bicycles will pass the test is 90% and that Phase 3 will be undertaken.
Phase 3 consists of changing over current production line to produce the new design. This would cost Sh.1,100 million in year 2.
If the economy is strong at this point, the net value of cash flows would be Sh.3,500 million, while if the economy is weak the net value of cash inflows would be Sh.2,600 million. Both net values of cash inflows will be realised at the end of year 3 and both states of the economy are equally likely.
The company’s cost of capital is 13%.
Required:
(i) Using a decision tree, determine the project’s expected net present value (ENPV).
(ii) Calculate the project’s standard deviation of expected net present value and comment on the result.
(iii) Using the normal probability distribution, compute the probability that the project’s net present value will be at least Sh.80 million.
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