Faisalabad Sugar Mills is evaluating a new technology for its reproduction

equipment. The technology will have a three-year life, will cost Rs. 2,000, and will have an impact on

cash flows that is subject to risk. Management estimates that there is a fifty-fifty chance that the

technology will either save the company Rs. 2,000 in the first year or save it nothing at all. If nothing

at all, savings in the last two years would be zero as well. When here there is some possibility that in

the second year an additional outlay of Rs.300 would be required to convert back to the original

process, for the new technology may decrease efficiency. Management attaches a 40 percent

probability to this occurrence if the new technology "bombs out" in the first year. If the technology

proves itself in the first year, it is felt that second-year cash flows will be Rs3000, Rs. 2,800, and

Rs. 2,600 with probabilities of 0.30, 0.40 and 0.30, respectively. In the third year, cash flows are

expected to be either Rs. 300 greater or Rs. 300 less than the cash flow in period 2, with an equal

chance of occurrence, (Again, these cash flows depend on the cash flow in period 1 being Rs.2,000).

All figure may be read as 000 thousands.

i. Set up a tabular version of a probability tree to depict the cash-flow possibilities, and the

initial, conditional, and joint probabilities for Analysis purpose.

ii. Calculate a net present value for each of the three-year possibilities (that is, for each of

the eight complete branches in the probability tree) using a risk-free rate of 5 percent.

iii. Calculate the expected value of net present value for the project represented in the

probability tree.

iv. Analysis Reliant risk of the project.