The Alset car company, a prominent car manufacturer in France, may design a new electric based on...

Question:

The Alset car company, a prominent car manufacturer in France, may design a new electric based on the "Back to the Future" movies.

First, Alset would have to invest $10,000 in t = 0 for the design and testing of the new car. Alset's managers believe there is a 70% probability that the phase will be successful and the project will continue. If Stage 1 is not successful, the project will be abandoned at zero salvage value. The next stage, if undertaken, would consist of making the mock-ups and prototypes of three cars. This would cost $750,000 at t = 1. If the cars test well, Alset would go into production. If they do not, the mockups and prototypes could be sold for $500,000 in t =2. The managers estimate the probability is 80% that the cars will pass testing and that Stage 3 will be undertaken. Stage 3 consists of converting an unused production line to produce the new design. This would cost $2M at t = 2.

If the economy is strong at this point, the net value of sales would be $5.0M; if the economy is weak, the net value would be $1.8M. Both net values occur at t = 3, and each state of the economy has a probability of 0.5. Alset's corporate cost of capital is 14%.

Construct a decision tree and determine the projects expected NPV.

Decision Tree Analysis

Decision Tree analysis is a common way to represent the alternatives to be taken which uses a tree-like graph or model of decisions and their possible consequences, including chance of event outcomes, costs, and results. It also helps to form a detailed picture of the risks and rewards associated with each possible course of action.

To evaluate a project with decision tree, all NPV-s are calculated with possible probabilities and then the net value is calculated.

Answer and Explanation:

Construct a decision tree and determine the projects expected NPV.

We make a decision tree depending upon the details: (I = Investment, V = Value, P...

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Analyzing Business Problems Using Decision Trees & Payoff Tables

from Business 116: Quantitative Analysis

Chapter 5 / Lesson 5
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