3. Edward’s Cinema operates a multiplex cinema that has nine small theaters in o

Question

3. Edward’s Cinema operates a multiplex cinema that has nine small theaters in one building. Business has been good lately and management is considering a project that will add five screens at an estimated cost of $4 million. The success of the expansion depends on whether local demand over the next two years will support the additional capacity. Demand is believed to depend on the local economy. An economist at a California State University at Bakersfield has predicted a 80% probability of continued prosperity in the area and a 20% chance of a moderate downturn. Management feels that if prosperity continues the new theaters will generate a profit margin of $3 million in the first year and $4 million in the second. A moderate downturn would produce contributions of $1.5 and $2 million. Edward’s Cinema’s cost of capital is 12%.

a. Draw a decision tree for the project. b. Calculate the NPV along each path. Path 1 _____________________________________________________________________ Path 2 _____________________________________________________________________

c. Develop the probability distribution of the project’s NPV. NPV Probability ____________ ________ ____________ ________

d. Calculate the project’s expected NPV. _________________________________________________________________________________________________________________________________________________________________________________________________________________________________ e. Make a recommendation on the project with an appropriate comment on risk. ____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

Explanation / Answer

1) Decision Tree

2) NPV in both cases

3) Probablity distribution for projects NPV

4) Expecyed NPV is 1143403.8 as shown and explained above

In case of continued prosperity 80% Year 1 Year 2 Year 0 (Initial Investment) 3000000 4000000 -4000000 In case of moderate downturn 20% Year 1 Year 2 1500000 2000000

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