FUNO_C14.

qxd 9/19/08 17:04 Page 374

Problems
1. Naughty Pine Lumber Company is evaluating a new saw with a life of two years. The saw
costs $3,000, and future after-tax cash flows depend on demand for the company’s pro-
ducts. The tabular illustration of a probability tree of possible future cash flows associated
with the new saw is as follows:
YEAR 1 YEAR 2
INITIAL NET CONDITIONAL NET
PROBABILITY CASH PROBABILITY CASH
P(1) FLOW P(2 | 1) FLOW BRANCH
0.30 $1,000 1
0.40 $1,500 0.40 $1,500 2
0.30 $2,000 3
1.00
0.40 $2,000 4
0.60 $2,500 0.40 $2,500 5
0.20 $3,000 6
1.00 1.00

a. What are the joint probabilities of occurrence of the various branches?

b. If the risk-free rate is 10 percent, what is (i) the net present value of each of the six com-
plete branches, and (ii) the expected value and standard deviation of the probability
distribution of possible net present values?
c. Assuming a normal distribution, what is the probability that the actual net present
value will be less than zero? What is the significance of this probability?
2. Zello Creamery Company would like to develop a new product line – puddings. The
expected value and standard deviation of the probability distribution of possible net
present values for the product line are $12,000 and $9,000, respectively. The company’s
existing lines include ice cream, cottage cheese, and yogurt. The expected values of net
present value and standard deviation for these product lines are as follows:
EXPECTED NET
PRESENT VALUE σ NPV
Ice cream $16,000 $8,000
Cottage cheese $20,000 $7,000
Yogurt $10,000 $4,000

The correlation coefficients between products are

ICE CREAM COTTAGE CHEESE YOGURT PUDDING
Ice cream 1.00
Cottage cheese 0.90 1.00
Yogurt 0.80 0.84 1.00
Pudding 0.40 0.20 0.30 1.00

a. Compute the expected value and the standard deviation of the probability distribution
of possible net present values for a combination consisting of the three existing products.

••
FUNO_C14.qxd 9/19/08 17:04 Page 375

b. Compute the expected value and standard deviation for a combination consisting of
existing products plus pudding. Compare your results in Parts (a) and (b). What can
you say about the pudding line?
3. Zydeco Enterprises is considering undertaking a special project requiring an initial outlay
of $90,000. The project would have a two-year life, after which there will be no expected
salvage or terminal value. The possible incremental after-tax cash flows and associated
probabilities of occurrence are as follows:
YEAR 1 YEAR 2
INITIAL NET CONDITIONAL NET
PROBABILITY CASH PROBABILITY CASH
P(1) FLOW P(2 | 1) FLOW BRANCH
0.30 $20,000 1
0.30 $60,000 0.50 $30,000 2
0.20 $40,000 3
1.00
0.30 $40,000 4
0.40 $70,000 0.40 $50,000 5
0.30 $60,000 6
1.00
0.20 $60,000 7
0.30 $80,000 0.50 $70,000 8
0.30 $80,000 9
1.00 1.00

The company’s required rate of return for this investment is 8 percent.

a. Calculate the expected net present value of this project.
b. Suppose that the possibility of abandonment exists and that the abandonment value of
the project at the end of the first year is $45,000 after taxes. For this project, would
abandonment after one year ever be the right choice? Calculate the new expected net
present value, assuming that the company would abandon the project if it is worthwhile
to do so. Compare your calculations with those in Part (a). What are the implications
for you as a manager?

••