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: Investment $50m Forecast Contribution per Investment $25m Forecast Contribution per Investment $35m Forecast Contribution per Market Demand store $4,250,000 $5,000,000 store store $3,500,000 $4,500,000 Medium High $2,000,000 $3,000,000 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: Investment $35m $1,200,000 Investment $50m $1,700,000 Investment $25m $700,000 Fixed costs per store 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

Answer A Particulars Forecasted contribution per store Fixed cost per store Profit per store $ $ $ Investment $25m Medium High 20,00,000 $ 30,00,000 $ 7,00,000 $ 7,00,000 $ 13,00,000 $ 23,00,000 $ Investment $35m Medium High 35,00,000 $ 45,00,000 $ 12,00,000 $ 12,00,000 $ 23,00,000 $ 33,00,000 $ Investment $50m Medium High 42,50,000 $ 50,00,000 17,00,000 $ 17,00,000 25,50,000 $ 33,00,000 Medium Answer B - Maximin Criteria for selection Different Market Demands Investments $25m $35m $50m $ $ $ 13,00,000 $ 23,00,000 $ 25,50,000 $ Worst / Minimum High of the two 23,00,000 $ 13,00,000 33,00,000 $ 23,00,000 33,00,000 $ 25,50,000 $ 25,50,000 Maximum of the three minimums

Thus, Investment of $50 million is most beneficial for the company.

Answer C

Another way of calculating the expected value of profit from the investment project is to assign probabilities to each outcome in each market demand conditions and then multiply those probabilities with each of their corresponding amounts of profits.

Which will lead to expected profit under each outcome and then the sum total of each medium and high market level demands will be the expected profit under that investment category. Thus, the maximum expected profit will be chosen.

What are the disadvantages of the EV method:

• probability values used are subjective in nature;
• no visual indication of the dispersion of possible outcomes - the risk of variable returns in a project;
• it is also seen as the merely weighted average method of calculation.