Question

Jupiter plc (Jupiter) owns a chain of pet shops in Geeland. As the economy in Geeland develops, pet ownership has increased and Jupiter now has the opportunity to expand its operation. The nature of this expansion includes developing both the range of pets and associated pet products sold as well as the number of physical stores. Jupiter has commissioned some market research into the viability of undertaking this additional investment. There are three potential levels of investment and two potential market conditions. The returns within one year are highlighted in the table below: Market Demand Investment $25m Forecast Contribution per store $2.000.000 $3,000,000 Investment $35m Forecast Contribution per store $3.500.000 $4,500,000 Investment $50m Forecast Contribution per store $4.250.000 $5.000.000 Medium High The investment would be for 25 new stores in all cases and the additional investment relates to the range of new pets and associated products stocked. The fixed costs per store will change depending upon the level of investment. These are listed below: Fixed costs per store Investment $25m $700,000 Investment $35m $1,200,000 Investment $50m $1,700,000 Required: a) Prepare a profit table for each outcome. (9 marks) b) Advise Jupiter which investment level should be chosen if the maximin decision criteria is applied. Justify your answer. (3 marks) c) Explain how probabilities can be used to calculate expected value and the limitations of expected value in risk assessment. (8 marks) TOTAL 20 MARKS

Answer 1

(a) Profit table for Jupiter Inc., for each outcome
	Investment $ 25M		Investment $ 35M		Investment $ 50M
	Medium	High	Medium	High	Medium	High
Forecast Contribution	50,000,000	75,000,000	87,500,000	112,500,000	106,250,000	125,000,000
Fixed Costs	17,500,000	17,500,000	30,000,000	30,000,000	42,500,000	42,500,000
Operating Profit	32,500,000	57,500,000	57,500,000	82,500,000	63,750,000	82,500,000
Operating Profit per Store	1,300,000	2,300,000	2,300,000	3,300,000	2,550,000	3,300,000
(b)
Table showing the payoff available at the lowest contribution level under each outcome
	Investment $ 25M		Investment $ 35M		Investment $ 50M
	Medium	High	Medium	High	Medium	High
Forecast Contribution	50,000,000	50,000,000	50,000,000	50,000,000	50,000,000	50,000,000
Fixed Costs	17,500,000	17,500,000	30,000,000	30,000,000	42,500,000	42,500,000
Operating Profit	32,500,000	32,500,000	20,000,000	20,000,000	7,500,000	7,500,000
The maximin decision rule that maximises the minimum pay off achievable.The worst case scenario is the contribution
margin at $ 25 million insvestment.The minimum payoffs achievable under the three investment scenarios are as under
Investment Scenario	Minimum Profits
Investment $ 25 million	32,500,000
Investment $ 35 million	20,000,000
Investment $ 50 million	7,500,000
As evident from the table above,the maximum payoff under the worst case scenario would be achieved at $ 25 million
investment.
Hence, the maximin decision creteria would choose the Investment level of $ 25 million,because the net operating
income under the chosen investment level would be the highest.
(c.)
Probability means the liklihood of an outcome from among the various possible outcomes.Expected Value is
calculated by the multiplying each possible outcome by the probability factor defined for that outcome. The expected
value would be the sum total of all the values computed for which different probabilities are assigned.
The limitations of expected value in risk assessment can be enumerated as under:
(i) The probability factors used to compute expected value are usually very subjective.
(ii) The expected value is merely the weighted average and hence is not useful for a oneoff project.
(iii) The expected value may not correspond to any of the actual possible outcomes.
(iv) The expected value gives no indication of the risk factor of the possible outcomes.