Moreover, the upgradation is successful at the end of year one, or equivalently,

the beginning of year two, some uncertainty in the subsequent incremental

cash flows attributable to this upgradation is resolved, but

not completely.

In this case, it is estimated that the sum of the incremental cash

flows from year two onwards till the life of the project,

when the entire information system will be changed completely.

Discounted to the end of year two is expected to be 300 with a probability

0.6 or 150 with probability 0.4.

This uncertainty whether it will 300 or

150 is not resolved at the beginning of year two.

On the other hand, if the upgradation of the information system is not a success,

then incremental cash flows attributable to this upgradation during the first

year will be only ten in thousands with probability 1- 0.55 = 0.45.

In this situation, it is estimated that the sum of the incremental cash flows from

year two onwards till the life of the project, discounted to the end of year two

would be 200 with probability of 0.6 or 100 with probability 0.4.

Again, this uncertainty whether it will be 200 or

100 is not resolved the beginning of year 2.

The yearly discount rate for this project is assumed to be 10%.

The first project is to upgrade the information system now.

The data are represented in a diagram as shown.

This diagram is an effort as to the tree.

Using the data represented in the tree,

the decision problem is whether to accept the project or not.

A typical approach to solving this decision problem

is to use the Net Present Value Rule, which states that,

accept the project if NPV is greater than zero.

Otherwise, reject the project.

We'll illustrate the application of NPV for this problem.

We'll start at the end node.

In this example, we have two end nodes, namely denoted as 1a and 1b.

We must consider each end node in turn, and

work backwards still we reach the starting node denoted as b.

The calculations are done as follows.

At node 1a, the value of the expected incremental future cash flows of 300 and

150 are multiplied by the respective probabilities of 0.6 and 0.4, and

added to arrive at the total.