Suppose you are considering setting up a new firm, where demand may be high, medium, or low with equal probability. The corresponding cash flows associated with each type of demand are the following:

These cash flows will begin one year after the investment is made and continue forever. The cost of the project is $5 today. The discount rate is 50%.

(a) What is the NPV of the project?

(b) Suppose you can commission a study that tells you what demand will be. The study takes two years to complete. What is the NPV of the project if you commission the study?

(c) Suppose that you can commission a study that takes only one year to complete, but that gives less precise information than in part b). The result of the study will be either positive or negative with equal probability. When the result is positive, demand will be high with probability 2/3 and medium with probability 1/3 (and thus low with probability zero). When the result is negative, demand will be low with probability 2/3 and medium with probability 1/3. What is the NPV of the project if you commission this type of study?

Demand Annual Cash Flows High 10 Medium 5 Low -10