Duqm Chemical Company is contemplating to invest in a new project which costs RO

Question

Duqm Chemical Company is contemplating to invest in a new project which costs RO 100,000. T below: he expected cash flow on this project under various scenarios are given End of year 1 (RO) End of Year 2 (RO) State of Economy Recession Growth Boom Probabilit 0.3 0.5 0.2 50,000 75,000 100,000 75,000 100,000 150,000 Assume that the state of the economy will be the same in the second year as in the first. The required rate of return is 8%. There is no tax or inflation. Required: (4 Marks) 1. Calculate Expected NPV 2. Calculate the Standard Deviation of NPV (4 Marks) 3. Appraise the management about this project with your comments. (2 Marks)

Explanation / Answer

1 Expected NPV State of economy (i) Probability(ii) Cash flows at the end of year 1(RO) (ii) Cash flow (iii=ii*ii) Cash flows at the end of year 1(RO) (iv) Cash flow (v=ii*iv) Recession 0.3 50000 15000 75000 22500 Growth 0.5 75000 37500 100000 50000 Boom 0.2 100000 20000 150000 30000 Expected CF 72500 102500 Expected CF (i) PV factor @8% = 1/1+rn (ii) Total Present value (iii=i*ii) 72500 0.926 67135 102500 0.857 87843 Inflow 154978 Less: Outflow 100000 Expected NPV 54978 2 Standard deviation of NPV Year 1 (Cash flow - expected cash flow)2      (i) Probability (ii) Variance (iii=i*ii) (50000-72500)*2 = - 22500*2 = 45000 0.3 13500 (75000-72500)*2   = 2500*2    = 5000 0.5 2500 (100000-72500)*2 = 27500*2   = 55000 0.2 11000 Total 27000 Standard deviation = Square root of variance = 27000 = 164.32 Year 2 (Cash flow - expected cash flow)2      (i) Probability (ii) Variance (iii=i*ii) (75000-102500)*2 = -27500*2 = 55000 0.3 16500 (100000-102500)*2   = -2500*2    = 5000 0.5 2500 (150000-102500)*2 = 47500*2   = 95000 0.2 19000 Total 38000 Standard deviation = Square root of variance = 38000 = 194.94    n Standard deviation of the expected NPV   = 2t/(1+i)2t t=1    =   164.32/1.082+194.94/1.084 = 16.86 3 Comments As the standard devaiation for the year 2 is higher than year 1 , hence the project for the Year 1 can be accepted than Year 2.

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