The staff of Porter Manufacturing has estimated the following net after-tax cash flows and probabilities for a new manufacturing process:
Line 0 gives the cost of the process, Lines 1 through 5 give operating cash flows, and Line 5* contains the estimated salvage values. Porter's cost of capital for an average-risk project is 10%.
Net After-Tax Cash Flows
Year P = 0.2 P = 0.6 P = 0.2
0 -$100,000 -$100,000 -$100,000
1 20,000 30,000 40,000
2 20,000 30,000 40,000
3 20,000 30,000 40,000
4 20,000 30,000 40,000
5 20,000 30,000 40,000
5* 0 20,000 30,000
1. Assume that the project has average risk. Find the project's expected NPV. (Hint: Use expected values for the net cash flow in each year.)
2. Find the best-case and worst-case NPVs. What is the probability of occurrence of the worst case if the cash flows are perfectly dependent (perfectly positively correlated) over time?
3. Assume that all the cash flows are perfectly positively correlated. That is, assume there are only three possible cash flow streams over time-the worst case, the most likely (or base) case, and the best case-with respective probabilities of 0.2, 0.6, and 0.2. These cases are represented by each of the columns in the table. Find the expected NPV, its standard deviation, and its coefficient of variation for each probability.