Green Mouse Industries CO. is panning to add a new product line to make However,

Question

Green Mouse Industries CO. is panning to add a new product line to make However, Green Moose Industries is considering the possibility of abandoning the project if the demand for the new product is low. In the following decision tree table, (1), (2) and (3) represent decision points, also known as decision nodes or stages. The dollar value to the right of each represents the net cash flow at that point, and the cash flows shown under t = 3, 4, and 5 represent the cash inflows if the project to completion. If Green Moose Industries Co. decides to launch the new line for iToys at Stage (1), then it will spend $80,000 on the marketing study. If the yields positive results, then the firm will spend $300,000 on the prototype. If the prototype works well, then the firm will spend several millions more at Stage to build a production plant. Suppose that as an analyst at Green Moose Industries you have to analyze sequential decision. By studying the following decision tree, you learn which of the following? Check all that apply. There is a 25% probability that the marketing study will produce positive results. There is a probability of 75% that the marketing study will produce positive results. There is a 25% probability that the marketing study will produce negative results. There is a 30% probability of the pilot project yielding average results. Complete the decision tree table by calculating the net present values (NPVs) and joint probabilities, as wet as products of joint probabilities and NPVs for each decision branch. Assume that the weighted average cost of capital (WACC) is 8% for all decision branches.

Explanation / Answer

Abandonment of a project means stopping a project before the end of its physical life. The Green Moose Industries CO has decided to introduce new product line to make toys but there is a probability of the abandonment of project if the demand for it is low. The company spends $80000 for its marketing of a new project and if the response is positive then it spends $300000 for its prototype. So there is a 25% chance that the marketing strategy will yield negative results . Each year the expected net cash flows are as follows:

ENCF1 = .5*$4761 + .2 * $1900= $2760.5

ENCF2 = .5*$8237 + .2* $2345 = $4587.5

ENCF3 = .5*$20065 + .2 * $7800 = $11592.5

So to calculate NPV we need to discount the expected net flows with a discount rate which is the weighted average cost of capital and reduce the initial investment

NPV 1 = 2760.5/1.08 =2556 –(80+300+7134)= -$4958

NPV 2 = 4587.5/(1.08)^2 =3933 – 7514 = -$3581

NPV 3 = 11592,5/(1.08)^3=9202 – 7514 = $1688

Joint probabilities are :

.5 * .75=.375

.2*.75 = .15

.3 * .75= .225

.25 *0 = 0

So Joint NPV= -4958* .375= -$1859.25

.15 * -3581 =- $537.15

.225 *1688 =$379.8

Joint NPV = 0

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