3

Keener Clothiers Inc. is considering investing $2 million in an automatic sewing machine to produce a newly designed line of dresses. The dresses will be priced at $200, and management expects to sell 12,000 per year for six years. There is, however, some uncertainty about production costs associated with the new machine. The production department has estimated operating costs at 70% of revenues, but senior management realizes that this figure could turn out to be as low as 65% or as high as 75%. The new machine will be depreciated at a rate of $200,000 per year (straight line, zero salvage). Keener's cost of capital is 13%, and its marginal tax rate is 39%. Calculate a point estimate along with best- and worst-case scenarios for the project's NPV. Round the answers to the nearest dollar.

Best-case scenario. Enter your answer in dollars. For example, an answer of $1.2 million should be entered as 1,200,000, not 1.2. $ Point estimate. Use a minus sign to indicate a negative NPV. Enter your answer in dollars. For example, an answer of $1.2 million should be entered as 1,200,000, not 1.2. $ Worst-case scenario. Use a minus sign to indicate a negative NPV. Enter your answer in dollars. For example, an answer of $1.2 million should be entered as 1,200,000, not 1.2. $

10

Work Station Inc. manufactures office furniture. The firm is interested in "ergonomic" products that are designed to be easier on the bodies of office workers who suffer from ailments such as back and neck pain due to sitting for long periods. Unfortunately, customer acceptance of ergonomic furniture tends to unpredictable, so a wide range of market response is possible. Management has made the following two-year probabilistic estimate of the cash flows associated with the project arranged in decision tree format ($000).

Work Station is a relatively small company and would be seriously damaged by any project that lost more than $1.5 million. The firm's cost of capital is 18%. Assume Work Station Inc. has an abandonment option at the end of the first year under which it will recover $5 million of the initial investment in year 2.

Develop a probability distribution for NPV based on the initial forecast. In other words, calculate the project's NPV along each path of the decision tree and the associated probability. Enter your answers for NPV in thousands. For example, an answer of $1.2 thousand should be entered as 1.2, not 1,200. Round your answers for NVP to one decimal place. Use a minus sign to indicate a negative NPV. Do not round intermediate calculations. Round PVF values in intermediate calculations to four decimal places. Round your answers for probability to two decimal places.

	NPV ($000)	Probability
Path 1	$
Path 2	$
Path 3	$
Path 4	$

Calculate the project's expected NPV. Enter your answer in thousands. For example, an answer of $1.2 thousand should be entered as 1.2, not 1,200. Round your answer to one decimal place. Do not round intermediate calculations. Round PVF values in intermediate calculations to four decimal places.

$ thousand

What is the value of the ability to abandon the project? Enter your answer in thousands. For example, an answer of $1.2 thousand should be entered as 1.2, not 1,200. Round your answer to one decimal place. Do not round intermediate calculations. Round PVF values in intermediate calculations to four decimal places.

$ thousand

Analyze your results and make a recommendation about the project's advisability considering both expected NPV and risk. How has the abandonment option affected the project's risk characteristics?

The project has become more acceptable

The project has become less acceptable