Question

Ch 13: Assignment-Capital Budgeting: Estimating Cash Purple Whale Inc. Co. is planning to add a new product line to make iToys. However, Purple Whale Inc. is considering the possibility of abandoning new product is low project if the demand for the 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 decision node 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 is pushed on completion. If Purple Whale Inc. Co. decides to launch the new line for IToys at Stage (1), then it will spend $80,000 on the marketing study. If the marketing study 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 (3) to build a production plant. Suppose that as an analyst at Purple Whale Inc. you have to analyze sequential decisions. By studying the following decision tree, you learn which of the following? Check all that apply There is a 30% probability of the pilot project yielding average results. 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. Complete the decision tree table by calculating the net present values (NPVS) and joint probabilities, as well 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. Hint: Use either a spreadsheet program's functions or a financial calculator for this task. Round the NPVS to thenearest dollar and remember to enter the minus sign if a value is negative. Note: All cash amounts in the following table are in thousands of dollars

Answer 1

Step 0	Step 1		Step 2		Step 3	Step 4	Step 5
1st investment	Probability	2nd investment	Probability	3rd investment	Inflow	Inflow	Inflow	NPV ($'000s)	Joint Probability (%)	NPV*Joint Prob.($'000s)
CF0	P1	CF1	P2	CF2	CF3	CF4	CF5
			50%	(10,269)	4,761	8,237	20,065	14,327.99	37.50%	5,373
	75%	(300)	20%	(10,000)	1,900	2,345	7,800	(390.69)	15.00%	(59)
(80)			30%	Stop	-	-	-	(357.78)	22.50%	(81)
	25%	Stop		-	-	-	-	(80)	25.00%	(20)
									Expected NPV	5,214

Formulas: NPV for a branch = CF0 + CF1/(1+8%)^1 + CF2/(1+8%)^2 + CF3/(1+8%)^3 + CF4/(1+8%)^4 + CF5/(1+8%)^5

Alternatively, the NPV() formula can be used for the calculation.

Joint probability = P1*P2

The project has a positive NPV so the company can accept the project.