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(b) PJP, an industrial manufacturer, is considering a new capital investment project to make and produce and sell a new type of electrical generator.
(b) PJP, an industrial manufacturer, is considering a new capital investment project to make and produce and sell a new type of electrical generator. The first stage of the project requires an investment of $8,000 now for the initial design and market research. There is a 40% probability that this phase will be successful. If it is not successful (probability 60%), the project will be abandoned with zero salvage value. If the first stage is successful, a further investment of $300,000 will be required one year from now to make and test prototype generators. If this second stage is not successful (probability 55%), the prototypes could be sold for $40,000. If it is successful (probability 45%), PJP would go ahead and produce the generator. Further machinery for full production would cost $600,000 two years from now. The net cash flows from production and sales of the generator will be either $250,000 or $200,000 every year into perpetuity, depending on whether the demand is strong (probability 50%) or weak (probability 50%). Assume these cash flows occur at the year ends with the first of them occurring three years from now. PJP's cost of capital is 10%. Assume investors are risk-neutral. Construct a decision tree and determine the expected Net Present Value of the project. Should the project be undertaken? (12 marks)
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