Happy Limited is considering expanding its production capacity with the installation of new equipment that will cost $950 000. This equipment is expected to have a useful life of 8 years, when it will be disposed of at a scrap value of $25 000.

Import duties on the equipment would amount to 2% of purchase price. Installation and testing costs would be $15 000. To support the expanded capacity, net working capital would have to be increased by $29 000. The new equipment would result in annual net operating cash inflows of $300 000.

Happy Limited's cost of capital is 16% and the tax rate is 25%.

1. Compute initial, annual and terminal after-tax cash flows.

1. Use the NPV method to advise Happy Limited on the effect that installing the new equipment will have on the value of the firm.

Explain TWO (2) real options that may serve to reduce the risk of a capital project