STION 2 (20 marks) The Yoruba Company (YC) is attempting to build a new robot vacuum and this project has a two year life. First, YC would have to invest $150,000 at t = 0 for the lengthy development phase. At the end of the year at t = 1, a further $75,000 is required for the actual production. Cash inflows from sales will occur at the end oft=2. Management is very aware of the uncertainty about the amount of cash inflows as it is unclear whether the market will embrace such a new innovative device. The management team believes there is a 75 percent probability that the new device will be a success. They also believe that the direction of device will become more apparent over the next year. In particular, there is an 80 percent chance that the direction over the next year will continue over the subsequent year. If the device is initially a success and this direction continues in the next year, the payoff will be $475,000. If the device is a success but does not continue to be a success in the subsequent year, the payoff is $185,000. If the device is initially unsuccessful but reverses trend in the following year, the payoff is $215,000. If the device is initially not a success and this direction continues in the subsequent year, the payoff is -$125,000. Suppose also that the required return on projects of this type is 11 percent. a) Construct a decision tree. (8 marks) b) Determine the expected NPV of the project. Show all appropriate calculations. (7 marks) c) What are the advantages of undertaking decision tree analysis? (5 marks) STION 2 (20 marks) The Yoruba Company (YC) is attempting to build a new robot vacuum and this project has a two year life. First, YC would have to invest $150,000 at t = 0 for the lengthy development phase. At the end of the year at t = 1, a further $75,000 is required for the actual production. Cash inflows from sales will occur at the end oft=2. Management is very aware of the uncertainty about the amount of cash inflows as it is unclear whether the market will embrace such a new innovative device. The management team believes there is a 75 percent probability that the new device will be a success. They also believe that the direction of device will become more apparent over the next year. In particular, there is an 80 percent chance that the direction over the next year will continue over the subsequent year. If the device is initially a success and this direction continues in the next year, the payoff will be $475,000. If the device is a success but does not continue to be a success in the subsequent year, the payoff is $185,000. If the device is initially unsuccessful but reverses trend in the following year, the payoff is $215,000. If the device is initially not a success and this direction continues in the subsequent year, the payoff is -$125,000. Suppose also that the required return on projects of this type is 11 percent. a) Construct a decision tree. (8 marks) b) Determine the expected NPV of the project. Show all appropriate calculations. (7 marks) c) What are the advantages of undertaking decision tree analysis
