Consumer Power Company (CPC) is consider a two-year transmission project. CPC has two options; fully funding the project at time 0, or spread funding over the project.

When fully funded at time 0, the project has a net present value of K150 million. Alternatively, the company has an option of making a partial investment of K1,000 million at the beginning of year 1 (time = 0), followed by a further investment at the beginning of Year 2 (t = 1). With regards the investment at the end of year 2, there are three (3) possible types of technologies available. Type 1 will cost K700 million, Type 2 will cost K500 million, and type 3 will cost K300 million. The actual technology chosen will depend on the performance of the economy in year 1. If the economy had a good growth, CPC would consider investing in either Type 1 or 2. If the economy gets bad growth, the company would consider either Type 3 or not invest at all.

In year1, CPC is expecting to earn K1,300 million if the economy performs well; or K500 million if the economy performs poorly. In year 2, the company is expecting a type 1 investment to yield either K1,600 million if the economy performs well, or K1,000 million if it performs poorly. A type 2 investment is expected to yield K700 million or K200 million for a good or poor economy, respectively. A type 3 investment is expected to yield K800 million or K600 million for a good or poor economy, respectively. Nothing is expected under the no- further- investment scenario if the economy performs poorly. However, this scenario is expected to yield K400 million should the economic performance be good.

All the earnings represent actual cashflows. There is an equal likelihood of a good or bad economy in year 1; and a 40% likelihood of good economy in the year 2. Assume that the overall rate of return on the LUSE is 9%, the risk-free rate is 4%, and CPC has a beta of 1.2.

Required:

1. Prepare a Decision Tree of this project and determine which investment should be made at the beginning of Year 2. [5 Marks]
2. Determine the expected volatility in the earnings of each of the four scenarios in year 2. [5 Marks]

3. Determine the net present value of the partial funding option at year 0.

[5 Marks]

4. What is the value of the partial funding option? [5 Marks]

5. Briefly explain the limitations of this approach to investment analysis.