218 Corporate Finance
The cash flows for each alternative outcome are:- A large plant with high volume would yield Rs 10 lac annually in cash flow.
- A large plant with low volume would yield Rs 1 lac.
- A small plant with low demand would yield Rs 4 lac.
- A small plant during an initial period of high demand, would yield Rs 4.5 lac per year and drop to Rs 3 lac
per annum in the long run because of the competition. - If the small plant were expanded to meet sustained high demand, it would yield Rs 7 lac cash flow
annually as it would be less efficient than a large plant built initially - If the plant was expanded but high demand was not sustained, estimated annual cash flow would be Rs 5
lac.
Cost of large plant = Rs 30 lac
Cost of small plant = Rs 13.1 lac
Cost of expansion = Rs 22.1 lacThe decision tree shown in Exhibit 11.6 has to be modified to incorporate the financial and probability data.
The modified decision tree is shown in Exhibit 11.7 at the end of the chapter. Seven outcomes (1 through 8)
are possible.
The firm has to make a decision whether to build a big plant or a small one now (time to). We can answer
this question by computing the expected NPV of each strategy.
Expected NPV of Building a Big Plant
- Calculate the expected present value of cash flows at chance node A. (upper-half of Exhibit 11.8)
E (PV) = PV × Probability
PV = [(10 lac × PVIFA 15,10) 0.6 + {1 × PVIFA 15,2 + 1 lac × PVIFA15,8}0.1- (100000 × PVIFA15,10) × 0.30]
= Rs 2164880
- (100000 × PVIFA15,10) × 0.30]
- Deduct the initial investment of Rs.3 m to get NPV
= 2164880 – 3000000
= – Rs 164880
Expected NPV of Building a Small Plant
- Calculate the expected value at C & D.
Expected value at C= [(700000 × PVIFA15,8) 0.86 + (50000 × PVIFA15,8) 0.14]
= Rs 2732583
Deduct investment of Rs 2.2 m to get NPV
= Rs 532583
Expected value at D= [(300000 × PVIFA 15,8) 0.86 (400000 × PVIFA15,8) 0.14]
= Rs 1408918
Since there is no investment,
NPV = Rs 1408918