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Computing the Expected Net Present Value

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Athens Development Corporation is considering a new product that will be sensitive to both economic conditions and competitor response. The product manager has decided to focus on three economic conditions: weak economy, normal economy, and strong economy. Competitors either will or will not respond with a competitive product, and competitor response is unlikely unless economic conditions turn out to be strong. Annual cash flows for each of these conditions appear below. The product has a six-year life and will require an initial cash outlay of $332,000. The cost of capital is 7 percent. Should Athens invest in this product? Explain.
Competitor Weak Normal Strong
Response Economy Economy Economy

Yes $36,500 $52,000 $73,000
No $48,500 71,000 94,000

Please complete the table of net present values below:
Competitor Weak Normal Strong
Response Economy Economy Economy

Yes $ ______ $______ $______
No $ ______ $______ $______

As a follow on to the prior problem, assume that the investment committee determined the probabilities below:
Probability the competitor will response 40%, will not respond 60%
Probability of each economic state over the six year horizon Weak - 10%., Normal - 60% and Strong 30%

Please complete the table of joint probabilities (by multiplying the economy probability by the competitor response probability) below and then calculate the expected net present value.
Competitor Weak Normal Strong
Response Economy Economy Economy

Yes ______% ______% ______%
No ______% ______% ______%

The expected net present value is ________________.

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Solution Summary

This solution illustrates how to compute a project's net present value under different economic and competitive conditions, how to create a table of joint probabilities, and how to compute the expected net present value.

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Year Method A Method B
0 ($300,000) ($120,000)
1 (66,000) (96,000)
2 (66,000) (96,000)
3 (66,000) (96,000)
4 (66,000) (96,000)
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Year Project X Project Y
0 ($10,000) ($10,000)
1 6,500 3,000
2 3,000 3,000
3 3,000 3,000
4 1,000 3,000

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Probability NPV
0.05 ($700,000)
0.20 (250,000)
0.50 120,000
0.20 200,000
0.05 300,000

a. What are the project's expected NPV and standard deviation of NPV?
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Year Prob = 0.2 Prob = 0.6 Prob = 0.2
0 ($100,000) ($100,000) ($100,000)
1 20,000 30,000 40,000
2 20,000 30,000 40,000
3 20,000 30,000 40,000
4 20,000 30,000 40,000
5 30,000 40,000 50,000

The Year 5 values include salvage value. Heywood's corporate cost of capital is 10 percent.
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