You are considering setting up a firm to produce gadgets. The demand for gadgets can be high, medium, or low with equal probability. The corresponding cash flows are: Demand Annual Cash Flows High: 600 Medium:0 Low:(-600) These cash flows will begin one year after the investment is made and continue forever. The cost of the project is $300 today. The discount rate is 50% (yes, that’s not a typo).

a. What is the NPV of the project?

b. Suppose you can commission a study that tells you what the demand for gadgets will be. The study takes two years to complete. What is the NPV of the project if you commission the study?

c. Suppose that you can commission a different type of study that takes only one year to complete. The drawback of this type of study is that the information is less precise than in part b). The result of the study will be either “positive” or “negative” with equal probability. When the result is positive demand will be high with probability 2/3 and medium with probability 1/3 (and low with probability zero). When the result is negative demand will be low with probability 2/3 and medium with probability 1/3. What is the NPV of the project if you commission this type of study?

d. Which type of study, if any, should you commission?

Answer rating: 100% (QA)

While calculating npv for expected future cash flow we take in to account only successf... View the full answer