After graduating from school, our newly minted graduates decide to launch a vent
ID: 2797487 • Letter: A
Question
After graduating from school, our newly minted graduates decide to launch a venture "Likable Lunches."
To do this, our new grads would need to invest $1,000 at t=0 for the ingredients and menu development for these lunches. The assumption is that there is a 70% chance that this phase will be successful and will continue. If this stage is not successful, the lunch project would be scrapped with no left overs
The second stage would consist of designing packaging and delivery of these lunches. This is estimated to cost $25,000 at t =1. If the lunch design and delivery test well, Franzi and Tony would then go into production. If they do not, the designs could be sold for $5,000. Success for the second stage is estimated at 85%.
The third and final stage consists of purchasing an old Delmonte plant for lunch production. This would cost $200,000 at t =2.
If the lunch economy is strong, the net value of sales would be $600,000; if the lunch economy is in recession, the net value would be $300,000. There's a 50-50 chance of strong or weak lunch economy. Our new grads' Cost of Capital is 10%.
Do you see any potential decision-making issues in this case as it relates to probabilities?
Explanation / Answer
Expected Cost at t=0 with p=0.7
E(t=0) = -1000*0.7 = -700
Expected Cost at t=2 with p=0.85
E(t=1) = -25000*0.85 = -21,250
Expected Cost at t=3 with p=1.0
E(t=2) = -200,000*1.0 = -200,000
Expected Net Sales value with 600,000 at p=0.5 and 300,000 at q= 1-p = 0.5
E(Net Sales) = 600,000*0.5 + 300,000*0.5 = 450,000
Assume that net sale value will be from t=3 onwards
Lets calculate NPV at 10% discount rate
NPV = 0 = -700 -21,250/1.1 - 200,000/1.1^2 + 450,000/1.1^3
NPV = $152,784.22
The NPV is positive, with the given probabilities and expected payoff based on that, the graduates should go for the venture. We recognize the net sales value at t=0 or t=2 the NPV will be further up. This will be a good decision for them to investment.
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