The ABC Company has gathered the following information about the cash flows associated with a capital budgeting opportunity. The project will cost $10,000,000 to implement, and has a three year estimated economic life.
There is a 50% probability that the economy will be average during the first year of the project, a 30% chance it will be better than average and a 20% chance it will be worse that average. If the economy is average for the first year, there is a 60% chance it will be average in year 2, a 30% chance it will be better than average and a 10% chance it will be below average. If the economy is above average during year 1, there is a 50% chance it will be above average during year 2, a 30% chance it will be average and a 20% chance it will be worse than average. If the economy is below average during the first year, there is a 40% chance it will be below average the second year, a 40% chance it will be average, and a 20% chance it will be better than average.
If the economy is average for year 2, there is a 65% chance it will be average in year 3, a 30% chance it will be better than average and a 5% chance it will be below average. If the economy is above average during year 2, there is a 60% chance it will be above average during year 3, a 30% chance it will be average and a 10% chance it will be worse than average. If the economy is below average during the second year, there is a 50% chance it will be below average the third year, a 40% chance it will be average and a 10% chance it will be better than average.
If the economy is average during a year, the net cash flow for the year will be $4,000,000. If the economy is better than average during a year, the net cash flow for the year will be $5,200,000 and if the economy during a year is worse than average, the net cash flow for the year will be $3,100,000.
What are the annual net cash flows that should be used to evaluate the opportunity?
What is the internal rate of return for the proposal?