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Cash Flow and Probability

Debby's Dance Studios is considering the purchase of new sound equipment that will enhance the popularity of its aerobics dancing. The equipment will cost $25,000. Debby is not sure how many members the new equipment will attract, but she estimates that her increased annual cash flows for each of the next five years will have the following probability distribution. Debby's cost of capital is 11 percent.

Cash Flow...............Probability
$3,600..........................0.2
5,000............................0.3
7,400............................0.4
9,800............................0.1

a. What is the expected value of the cash flow? The value you compute will apply to each of the five years.
b. What is the expected net present value?
c. Should Debby buy the new equipment?

Solution Preview

a. A 'fair' or 'expected' value for a 20% chance at $3,600 would be 0.20* 3,600 which = $720.00
$5,000 at 0.30 = $1500.00
7,400 at 0.40 = $2,960.00
9,800 at 0.10 = $980.00

All the probabilities refer to the same dance studio, we can add those expected annual cash flows ...

Solution Summary

Cash flows and probabilities are determined.

$2.19