St Kilda Ltd. considers investing in a research project that produces two types of products: A and B. Product A is more innovative and will be produced only if the research is successful. If the research is not successful, the firm can modify the research outcome and will produce Product B, which is less innovative. The research is expected to take 2 years to complete. The firm can only tell if the development is a success or failure at the completion of the development. There is only a 41% chance that the research is successful and Product A will be produced. The research costs $3.2 million today.

If successful, Product A will be highly sought after and will earn the firm a net after-tax operating cash flow of $860,000 per annum over the following three years (starting from year 3). At the end of year 5, the firm will have an option to abandon the production depending on the demand for Product A. Management team believes that there is a 55% probability that demand for Product A will be high and the net after-tax operating cash flow will be $860,000 per annum in perpetuity starting from year 6. However, if the demand is low by the end of year 5, the firm will abandon the production and it will be able to salvage $110,000 by selling the production in year 5.

If the development fails, Product B will be produced and will earn the firm a net after-tax operating cash flow of $430,000 per year for the next three years. At the end of year 5, the firm will have an option to spend $290,000 to upgrade the production plant. If the demand for Product B is high in year 5 (with 39% probability), the firm will certainly upgrade Product B and the net after-tax operating cash flow will be $860,000 each year in perpetuity starting from year 6. However, if the demand for Product B is low in year 5, the firm will not upgrade the production and the net after-tax operating cash flow will be $430,000 each year in perpetuity starting in year 6. The companys cost of capital is 16 percent.

Required:

Should the firm undertake this project? Justify your decision. (6 marks)

Note: You are NOT required to draw a decision tree in the answer box.