DengCorp is considering a project ABC. The company is all equity financed. The project generates the following stream of net income (earnings after tax):

Year 0 0$

Year 1 -$5

Year 2 $0 or $8 each with 50% probability

The required investment at year 0 is $20, which is depreciated by 50% in each of the next two years (thus fully depreciated at the end of year 2).

At the end of year 2, the investment can be sold in the market for $5.

The project only requires $5 net working capital in year 1, which is recovered at the end of the project.

Tax rate is 40%. Discount rate is 10%.

a) Explain in the net present value analysis, why do we discount free cash flow instead of the net income? State and explain at least two key differences.

b) What is the free cash flow of project ABC in each year?

c) What is the NPV of project ABC? Should we implement this project?