In order to pursue a project, $500 must be spent now (t=0) to explore the project’s feasibility. Next year (t=1), the option or decision to continue or abandon the project will be exercised. The cost of capital is r=15% per year. If the project is accepted next year, it will cost an additional $1500 at t=1 and will produce cash flows in years 2 through 6 (t=2 through t=6 years).
Based on current forecasts, there is a 70% and 30% probability that cash flows CF2 through CF6 will be $1000 and $400 per year, respectively. At t=1, we will know
Whether the final outcome is $1000 or $400 per year.
Please make a Decision tree with Static NPV and Dynamic NPV.