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1) The mulligan machine works company is considering the routine investment opportunity that initially costs $450,000 and is expected to last for just 2 years. MMWC believes that there is 60% probability which demand will be high for 1st year of operation resulting in after tax cash flows of $400,000 for year one. If demand is low from the 1st year (40% probability) then MMWC expects cash flows of $175,000 for year one. Additional, there is 70% probability which demand will remain the same for year two. Or we can say, if demand is high (low) in year one, there is 70% probability it will remain high (low) in year two and 30% probability that it will be low (high) in year two. At end of year one, MMWC has option to invest the addition $200,000 to expand this project for year two. If expansion option is taken, high demand will effect in cash flows of $700,000 and low demand will result in cash flows of $400,000 in year two. If expansion option is not taken, then high demand cash flows will remain at $400,000. And low demand cash flows will stay at $175,000 in year two. The opportunity cost of capital for MMWC is 14%.

1) Sketch a decision tree for this problem.

2) What is the NPV for project under active management?

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Basic Finance, Finance

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