Xerox Knot Limited is subject to a 30% corporate tax rate. The risk-free rate is 4%. The market risk premium of 6% and the firms equity beta is 1.5. The firms debt financing which represents 40% of the overall financing is currently yielding 7.5% before tax. Xerox has a 45% debt in the capital structure.

Xerox is examining a project that will have an initial cost today of $5 million. There is significant uncertainty surrounding the first-year cash flows which create three possible cash-flow scenarios in Year 1. a. 30% probability that the cash flow after 1 year will be $6.5 million. b. 45% probability that the cash flow after 1 year will be $4.5 million. c. 25% probability that the cash flow after 1 year will be $2 million.

Conditioned on first-year cash flow performance outcome of scenario a, the second-year cash flow is likely to be 10 million (20% probability) or 6 million (60% probability), or 5.5 miles (20% probability).

If the first-year performance outcome of scenario b is realized, the second-year cash flow is likely to be 6.5 million (30% probability) or 3.2 million (40% probability), or -1.5 million (30% probability).

Finally, conditioned on first-year performance outcome of scenario c, the second-year cash flow is likely to be 3.0 million (35% probability), or -1.25 million (40% probability) or -3.5 million (25% probability).

Should the project be undertaken under NPV evaluation criteria? How would you characterize the risk of this investment?