A Capital Investment requires an initial outlay of $1,000. In the first year, it
ID: 2735419 • Letter: A
Question
A Capital Investment requires an initial outlay of $1,000. In the first year, it iwll provide cash flows of $300 with a probability of .3, or $600 with a probablity of .7. If cash flows in the first year are $600, they will be $700 or $800 in the second year, with a .5 probability of each outcome. if cash flows are $300 in the first year, they will be $300 in the second year. At a 10 percent required return, find each possible net present value and its associated probablity. Is this investment attractive?
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Explanation / Answer
Initial Outlay = $1,000
If $600 in first year and $700 in second year
NPV = -1,000 + 600/1.10 + 700/1.10^2 = $123.97
Probability of this possibility = 0.7*0.5 = 0.35
If $600 in first year and $800 in second year
NPV = -1,000 + 600/1.10 + 800/1.10^2 = $206.61
Probability of this possibility = 0.7*0.5 = 0.35
If $300 in first year and $300 in second year
NPV = -1,000 + 300/1.10 + 300/1.10^2 = - $479.34
Probability of this possibility = 0.3*1 = 0.3
The investment is not attractive as the NPV is negative with 30% probability. And other aspect are having 35% chances.
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