Question

Unani Laboratories Limited (ULL) is considering a project for a new type of a herbal medicine which would provide immunity against viruses such as Covid-19. The cost of the project is PKR 60 million. The future cash flows of the project depend on the demand for the medicine, which is uncertain. The company believes that there is a 25 percent chance that demand for the new medicine will be very high, in which case the project will generate cash flows of PKR 35 million each year for 3 years. There is a 50 percent chance of average demand with cash flows of PKR 30 million each year for 3 years. There is a 25 percent chance that the demand will be low and annual cash flows will be only PKR 10 million each year for three years. The cost of capital is 13%. ULL could accept the project and implement it immediately. The company has acquired a patent on the medicine. Therefore, ULL can also choose to delay the implementation of the project by one year, when more information about demand will be available. If delayed by one year, the investment cost will still be PKR 60 million and the project is expected to generate the same cash flows as indicated above, but each cash flow will be pushed back one year. If ULL waits for one year, it will know which of the demand conditions, hence which set of cash flows, will exist. The company will make the investment only if demand is sufficient to provide a positive NPV.

Requirements
Make decision Tree ??
answer which condition will you choose and why??

Make decision and find out NPV of both conditions .

Answer 1

(I) If the company immediately accept the project(3 Cases)
Case 1 ( The company believes that there is a 25 percent chance that demand for the new medicine will be very high, in which case the project will generate cash flows of PKR 35 million each year for 3 years)
Year	Cash Flows	Discounting factor at 13%	Present Value
0	(60,000,000)	1.000	(60,000,000.00)
1	35,000,000	0.885	30,973,451.33
2	35,000,000	0.783	27,410,133.92
3	35,000,000	0.693	24,256,755.68
Net Present Value	22,640,340.93
Case 2 (There is a 50 percent chance of average demand with cash flows of PKR 30 million each year for 3 years. )
Year	Cash Flows	Discounting factor at 13%	Present Value
0	(60,000,000)	1.000	(60,000,000.00)
1	30,000,000	0.885	26,548,672.57
2	30,000,000	0.783	23,494,400.50
3	30,000,000	0.693	20,791,504.87
Net Present Value	10,834,577.94
Case 3 (There is a 25 percent chance that the demand will be low and annual cash flows will be only PKR 10 million each year for three years.)
Year	Cash Flows	Discounting factor at 13%	Present Value
0	-60000000	1.000	(60,000,000.00)
1	10000000	0.885	8,849,557.52
2	10000000	0.783	7,831,466.83
3	10000000	0.693	6,930,501.62
Net Present Value	(36,388,474.02)

(II) If the company delay the project by 1 year(3 Cases) - Each cash flow will be pushed back one year.
Case 1
Year	Cash Flows	Discounting factor at 13%	Present Value
0	(60,000,000)	1.000	(60,000,000.00)
1	-	0.885	-
2	35,000,000	0.783	27,410,133.92
3	35,000,000	0.693	24,256,755.68
4	35,000,000	0.613	21,466,155.47
Net Present Value	13,133,045.07
Case 2
Year	Cash Flows	Discounting factor at 13%	Present Value
0	(60,000,000)	1.000	(60,000,000.00)
1	-	0.885	-
2	30,000,000	0.783	23,494,400.50
3	30,000,000	0.693	20,791,504.87
4	30,000,000	0.613	18,390,000.00
Net Present Value	2,675,905.37
Case 3
Year	Cash Flows	Discounting factor at 13%	Present Value
0	-60000000	1.000	(60,000,000.00)
1	0	0.885	-
2	10000000	0.783	7,831,466.83
3	10000000	0.693	6,930,501.62
4	10000000	0.613	6,130,000.00
Net Present Value	(39,108,031.54)
In both the conditions (I) and (II) the case 1 and case 2 gives a positive cashflows,ie a positive NPV, where as the case 3 gives a negative cash flow.
Its better for the company to wait for 1 year to understand the demand of the product and to take an investment decision on the project since after 1 year also the case 1 and case 2 gives positive cash flows.