Gomez Drug Products Company could invest in a new drug project with an estimated life of 3 years. If demand for the new drug in the first period is favorable, it is almost certain that it will be favorable in periods 2 and 3. By the same token, if demand is low in the first period, it will be low in the two subsequent periods as well. Owing to this likely demand relationship, an assumption of perfect correlation of cash flows over time is appropriate. The cost of the project is $1 million, and possible cash flows for the three periods are:

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a. Assuming that the risk-free rate is 8 percent and that it is used as the discount rate, calculate the expected value and standard deviation of the probability distribution of possible net present values.

b. Assuming a normal distribution, what is the probability of the project providing a net present value of (1) zero or less? (2) $300,000 or more? (3) $1,000,000 or more?

c. Is the standard deviation calculated larger or smaller than it would be under an assumption of independence of cash flows over time?


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