Problem 12-10

Work Station Inc. manufactures office furniture. The firm is interested in "ergonomic" products that are designed to be easier on the bodies of office workers who suffer from ailments such as back and neck pain due to sitting for long periods. Unfortunately, customer acceptance of ergonomic furniture tends to unpredictable, so a wide range of market response is possible. Management has made the following two-year probabilistic estimate of the cash flows associated with the project arranged in decision tree format ($000).

Work Station is a relatively small company and would be seriously damaged by any project that lost more than $1.5 million. The firm's cost of capital is 11%. Assume Work Station Inc. has an abandonment option at the end of the first year under which it will recover $5 million of the initial investment in year 2.

1. Develop a probability distribution for NPV based on the initial forecast. In other words, calculate the project's NPV along each path of the decision tree and the associated probability. Enter your answers for NPV in thousands. For example, an answer of $1.2 thousand should be entered as 1.2, not 1,200. Round your answers for NVP to one decimal place. Use a minus sign to indicate a negative NPV. Do not round intermediate calculations. Round PVF values in intermediate calculations to four decimal places. Round your answers for probability to two decimal places.

   	NPV ($000)	Probability
   Path 1	$ fill in the blank 1	fill in the blank 2
   Path 2	$ fill in the blank 3	fill in the blank 4
   Path 3	$ fill in the blank 5	fill in the blank 6
   Path 4	$ fill in the blank 7	fill in the blank 8

2. Calculate the project's expected NPV. Enter your answer in thousands. For example, an answer of $1.2 thousand should be entered as 1.2, not 1,200. Round your answer to one decimal place. Do not round intermediate calculations. Round PVF values in intermediate calculations to four decimal places.

   $ fill in the blank 9 thousand

   What is the value of the ability to abandon the project? Enter your answer in thousands. For example, an answer of $1.2 thousand should be entered as 1.2, not 1,200. Round your answer to one decimal place. Do not round intermediate calculations. Round PVF values in intermediate calculations to four decimal places.

   $ fill in the blank 10 thousand

3. Analyze your results and make a recommendation about the project's advisability considering both expected NPV and risk. How has the abandonment option affected the project's risk characteristics?

   The project has become more acceptableThe project has become less acceptableThe project has become more acceptable

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$7,000 0.3 S4,000 0.6 0.7 (56,000) $5,000 $3,000 0.8 0.4 S2,000 0.2 $2,400