Problem 12-11 Vaughn Clothing is considering refurbishing its store at a cost of $1.4 million. Management is concerned about the economy and whether a competitor, Viola Apparel, will open a store in the neighborhood. Vaughn estimates that there is a 60% chance that Viola will open a store nearby next year. The state of the economy probably won't affect Vaughn until the second year of the plan. Management thinks there is a 40% chance of a strong economy and a 60% chance of a downturn in the second year. Incremental cash flows are as follows:
Viola opens a store - $700,000
Viola doesn't open a store - $900,000
Viola opens a store, strong economy - $850,000
Viola opens a store, weak economy - $700,000
Viola doesn't open a store, strong economy - $1,500,000
Viola doesn't open a store, weak economy - $1,200,000
Look at the decision tree diagram ($000) and calculate the probabilities and NPVs along each of its four paths. Then calculate the overall expected NPV. Assume Vaughn's cost of capital is 17%. Enter your NPV answers in thousands of dollars and not in whole dollars. For example, an answer of $1.12 thousand should be entered as 1.12 not 1,120. Round the NPV answers to two decimal places. Use a minus sign to indicate a negative NPV. Do not round intermediate calculations. Round PVF values in intermediate calculations to four decimal places. Round your probability answers to two decimal places.
Overall expected NPV = $
Decision Tree is used in the decision-making process to select the best possible option among multiple alternatives or to assess the riskiness of a project. It is a pictorial representation of outputs (like NPV of a project or investment analysis) in multiple scenarios, generally attached with a predefined probability..
Answer and Explanation:
We draw the decision tree as below:
From the tree above we make the table as below:
See full answer below.
Become a member and unlock all Study Answers
Try it risk-free for 30 daysTry it risk-free
Ask a question
Our experts can answer your tough homework and study questions.Ask a question Ask a question
Learn more about this topic:
fromChapter 5 / Lesson 5