Chapter 3

Q. 3.PP.41

A company has made the following estimates of the CFAT associated with an investment proposal.
The company intends to use a decision tree to get a clearer picture of the project’s cash inflows. The project has an expected life of 2 years.
The equipment costs Rs 40,000 and the company uses a 10 per cent discount rate for this type of investment.
\,   (i) Construct a decision tree for the proposed investment project.
\,  (ii) What NPV will the project yield if the worst outcome is realised? What is the probability of
\,       occurrence of this NPV?
\, (iii) What will be the NPV if the best outcome occurs? What is its probability?
\, (iv) Will the project be accepted?

Probability                          CFAT\> (t = 1)
0.4                                          Rs 25,000
0.6                                                30,000
                   CFAT (t = 1)
0.2 If CFAT_1 = Rs 25,000 … Rs 12,000
0.3                                                  16,000
0.5                                                 22,000
0.4 If CFAT_2 = Rs 30,000 …      20,000
0.5                                                25,000
0.1                                                30,000


Verified Solution

\,  (ii) If the worst outcome is realised, the NPV of the project would be (Rs
\,         7,363).
\, (iii) If the best outcome, the NPV of the project would be Rs 12,050. There
\,       is a 6 per cent probability of this outcome.
\, (iv) Yes, the project should be accepted, as the project is expected to
\,       yield a positive NPV of Rs 3,111.88.