Zoom Technologies, Inc., is considering expanding its operations into digital music devices. Zoom anticipates an initial investment of $1.3 million and, at best, an operational life of 3 years for the project. Zoom’s management team has considered several probable outcomes over the life of the project, which it has labelled as either “successes” or “failures.” Accordingly, Zoom anticipates that in the first year of operations there is a 65% chance of ·success,” with after-tax cash flow of $800,000, or a 35% chance of “failure,” with a meagre $1,000 cash flow after tax.
If the project “succeeds” in the first year, Zoom expects three probable outcomes regarding net cash flows after tax in the second year. These outcomes are $2.2 million, $1.8 million, or $1.5 million, with probabilities of .3, .5, and .2, respectively. In the third and final year of operation, the net cash flows after tax are expected to be either $35,000 more or $55,000 less than they were in year 2, with an equal chance of occurrence.
If, on the other hand, the project “fails” in year 1, there is a 60% chance that it will produce net cash flows after tax of only $1,500 in years 2 and 3. There is also a 40% chance that it will really fail and Zoom will earn nothing in year 2, and will get out of this line of business, terminating the project and resulting in no net cash flows after tax in year 3.
The opportunity cost of capital for Zoom Technologies is 10%.
a. Construct a decision tree representing the possible outcomes.
b. Determine the joint probability of each possible sequence of events.
c. What is the project’s expected NPV?