2. The Z-90 project being considered by Steppingstone Inc. (SI) has an up-front

Question

2. The Z-90 project being considered by Steppingstone Inc. (SI) has an up-front cost of $250,000. The project's subsequent cash flows are critically dependent on whether another of its products, Z-45, becomes an industry standard. There is a 50% chance that the Z-45 will become the industry standard, in which case the Z-90's expected cash flows will be $110,000 at the end of each of the next 5 years. There is a 50% chance that the Z-45 will not become the industry standard, in which case the Z-90's expected cash flows will be $25,000 at the end of each of the next 5 years. Assume that the cost of capital is 12%.

Refer to Exhibit 14.4. Based on the above information, what is the Z-90's expected net present value?

A) -$6,678

B) -$3,251

C) $15,303

D) $20,004

E) $45,965

Explanation / Answer

EXPECTED INITIAL CASH FLOW IN YEAR 0 IS ($250000)

EXPECTED INBETWEEN CASH FLOW

YEAR   CASH FLOW   PROBABILITY     EXPECTED VALUE

1-5 $110000 0.5 $55000

1-5 $25000 0.5 $12500

   EXPECTED VALUE $67500

CALCULATION OF EXPECTED NPV

YEAR     CASH FLOW     DISCOUNTING FACTOR     DISCOUNTED CASH FLOW

0 ($250000) 1.000 ($250000)

1-5 $67500 3.60478 $243322.65

   EXPECTED NPV ($6677.35) APROX

ANSWER A

NOTE- THERE IS A LITTLE DIFFRENCE BECAUSE OF ROUNDING OF THE DECIMAL.

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