Suppose ZAN ltd. is evaluating a research proposal that requires an initial investment of Rs. 300,000. However,

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Question:

Suppose ZAN ltd. is evaluating a research proposal that requires an initial investment of Rs. 300,000. However, research has 30% probability of not succeeding. If the proposal fails, the firm would close the project. If the research is successful, the firm has two options.

Option A: Market the project

Option B: Sell out the research

If it decides to go with option A, they will have to make an additional investment of Rs. 50,000. If the firm chooses option A, it can either have cash flow of Rs. 700,000 or Rs. 150,000. The probability of getting a high cash flow is 0.7.

But if it decides to go with option B (no additional investment would be required), then it may receive Rs. 350,000 with a probability of 0.8. However, there is a probability of 0.2 that they may not be able to sell out the research.

Assume that initial investment would be made in period 0, decision regarding choosing option A or B and corresponding additional investments would be made in period 1, and cash flows would be received in period 2. The cost of capital is 10%.

a. Construct a decision tree representing each node clearly.

b. Calculate expected net present value.

c. Based on the expected NPV obtained in part (b), comment whether you should accept a project. Why or Why not?