Xonic Graphic is evaluating a new technology for its reproduction equipment. The

technology will have a 3-year life and cost $700. Its impact on cash flows is subject to risk.

Management estimates that there is 50-50 chance that technology will either save the

company $1,000 in the first year or save it nothing at all. If nothing at all, savings in the

last 2 years would be zero. Even worse, in the second year, an additional outlay of $300

may be required to convert back to original process, for the new technology may result in

less efficiency. Management attaches a 40 percent probability to this occurrence, given the

fact that new technology "bombs out" in the first year. If the technology proves it self, the

second-year cash flows may be either $1,800, $1,400 or $1,000 with probabilities of 0.30,

0.50 and 0.20, respectively. In the third-year cash flows are expected to be $200 greater or

$200 less than the cash flows in the period 2, with an equal chance of occurrence. (Again

these cash flows depend on the cash flows in the period 1 being $700). All cash flows are

after tax.

a) Set up a probability tree to depict the foregoing cash flow probabilities and compute

expected NPV and risk for aforesaid data if risk free rate of return is 9%.

b) Discuss risk and real options in capital budgeting analysis with the help of other then text

book example.