Question

Xonics Graphics, Inc., is evaluating a new technology for its reproduction equipment. The

technology will have a three-year life, will cost $1,000, and will have an impact on cash

flows that is subject to risk. Management estimates that there is a fifty-fifty chance that the

technology will either save the company $1,000 in the first year or save it nothing at all. If

nothing at all, savings in the last two years would be zero as well. Even here there is some

possibility that in the second year an additional outlay of $300 would be required to

convert back to the original process, for the new technology may decrease efficiency.

Management attaches a 40 percent probability to this occurrence if the new technology

“bombs out” in the first year. If the technology proves itself in the first year, it is felt that

second-year cash flows will be $1,800, $1,400, and $1,000, with probabilities of 0.20, 0.60,

and 0.20, respectively. In the third year, cash flows are expected to be either $200 greater

or $200 less than the cash flow in period 2, with an equal chance of occurrence. (Again,

these cash flows depend on the cash flow in period 1 being $1,000.)

Book: fundamentals-of-Financial Management_van-horne_wachowicz_13ed

Answer 1