Komarek Forests is considering a new software package that may improve productivity over the next two years. There is a sixty percent chance that the project will be a success in Year 1, earning $2 million and a forty percent change that the venture will fail during the first year resulting in a $1 million loss due to worse asset management than under the current system. The original system would be reinstalled, resulting in no additional losses during the second year. If the project is a success in the first year, there is an eighty percent chance that it will earn $3 million in the second year. There is a twenty percent chance that the software will be ineffective in Year 2, despite success in Year 1, in which case there would be a loss of $500,000. Assuming a nine percent required rate of return on these, and a total cost of the software system of $500,000, should Komarek install the new system?

Question

Komarek Forests is considering a new software package that may improve productivity over the next two years. There is a sixty percent chance that the project will be a success in Year 1, earning $2 million and a forty percent change that the venture will fail during the first year resulting in a $1 million loss due to worse asset management than under the current system. The original system would be reinstalled, resulting in no additional losses during the second year. If the project is a success in the first year, there is an eighty percent chance that it will earn $3 million in the second year.  There is a twenty percent chance that the software will be ineffective in Year 2, despite success in Year 1, in which case there would be a loss of $500,000. Assuming a nine percent required rate of return on these, and a total cost of the software system of $500,000, should Komarek install the new system?

Taryn Ashleigh · Accepted Answer

Final Answer :  1  = $2,000,000   CF 2  = $3,000,000  I = 9   Solve for NPV = $3,859,902  Path 2: Probability: 0.6 × 0.2 = 0.12  CF 0  = -500,000    CF 1  = $2,000,000    CF 2  = -$500,000  I = 9   Solve for NPV = $914,022  Path 3: Probability: 0.4  CF 0  = -500,000    CF 1  = -1,000,000     I = 9     Solve for NPV    = -$1,417,431  Expected Value = .48 ($3,859,902) + .12 ($914,022) + 0.4 (-$1,417,431)   $1,852,753 + $109,683 - $566,972 = $1,395,464  The present value of the project is a positive $1,395,464. However, there is forty percent chance of losing $1,417,431. Komarek Forests may conclude that the chance of loss is too great, and forego this positive NPV project. class=answers-bank-image d-block rel=preload > Path 1: Probability: 0.6 × 0.8 = 0.48CF0 = -500,000    CF 1  = $2,000,000   CF 2  = $3,000,000  I = 9   Solve for NPV = $3,859,902Path 2: Probability: 0.6 × 0.2 = 0.12CF 0  = -500,000    CF 1  = $2,000,000    CF 2  = -$500,000  I = 9   Solve for NPV = $914,022Path 3: Probability: 0.4CF 0  = -500,000    CF 1  = -1,000,000     I = 9     Solve for NPV    = -$1,417,431Expected Value = .48 ($3,859,902) + .12 ($914,022) + 0.4 (-$1,417,431)$1,852,753 + $109,683 - $566,972 = $1,395,464The present value of the project is a positive $1,395,464. However, there is forty percent chance of losing $1,417,431. Komarek Forests may conclude that the chance of loss is too great, and forego this positive NPV project.

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