Capital Budgeting (Finance)
Practice Set Chapters 11 and 12: Name_______________________________
Please type a numerical solution for each problem in the space provided below.
There are three outcomes from an expected course of action with the following probabilities:
The payoff is $150,000 with a 20% probability.
The payoff is $280,000 with a 50% probability.
The payoff is $460,000 with a 30% probability.
What is the expected value for this course of action?
Would a risk-averse investor be willing to pay the expected value for the opportunity to play? Explain.
If we open a casino there is a .60 probability that enough customers will come to our casino to make it commercially viable. Additionally, we must be awarded a gaming license before we are allowed to open the casino and the probability of getting this license is .25, what is the probability that we get our license, and the casino will be commercially viable?
Based on history, there is a .68 probability of a positive net present value when competitors do not respond to our introduction of a new product. Based on this same history, if competitors do respond, there is a .28 probability of a positive net present value. After studying history and the financial capabilities of our competitors going forward, we determine that there is a .30 probability that competitors will respond. What is the probability of a positive net present value?
Possible net present values and associated probabilities for a new investment are as follows:
NPV -15550 -3200 2600 4400 6000 9500 15600
Probability .15 .30 .10 .10 .10 .15 .10
What is the expected value______________, median, ______________ and mode _________________?
(Remember the median is the center based on probabilities)
Athens Development Corporation is considering a new product that will be sensitive to both economic conditions and competitor response. The product manager has decided to focus on three economic conditions: weak economy, normal economy, and strong economy. Competitors either will or will not respond with a competitive product, and competitor response is unlikely unless economic conditions turn out to be strong. Annual cash flows for each of these conditions appear below please remember the bracketed numbers are negative. The product has an eight-year life and will require an initial cash outlay of $520,000. The cost of capital is 7.4%. Should Athens invest in this product? Explain.
Competitor Weak Normal Strong
Response Economy Economy Economy
Yes $(136,500) $(62,000) $59,000
No $158,500 191,000 242,000
Please complete the table of net present values below:
Competitor Weak Normal Strong
Response Economy Economy Economy
Yes $ ______ $______ $______
No $ ______ $______ $______
As a follow on to the prior problem, assume that the investment committee determined the probabilities below:
Probability the competitor will response 30%, will not respond 70%
Probability of each economic state over the investment horizon is Weak = 30%., Normal = 60% and Strong = 10%
Please complete the table of joint probabilities (by multiplying the economy probability by the competitor response probability) below and then calculate the expected net present value.
Competitor Weak Normal Strong
Response Economy Economy Economy
Yes ______% ______% ______%
No ______% ______% ______%
The expected net present value is ________________.
Sam’s Pizza is considering a new store location. He estimates fixed operating costs for a store are $465,000 a year, and variable costs are 37 percent of sales. The average pizza sells for $18.75. Compute the annual break-even sales level in number of pizzas for this store location.
Bob’s Submarine Sandwiches expects annual sales of $735,000, annual fixed cash outlays are $226,750 a year, variable cash outlays are 38 percent of sales, depreciation is $36,000 per year, and taxes are 28% (of pretax income). Opening promotion, equipment, and seating costs require an initial outlay of $845,000. The company does its analysis based on a 20-year store life. Bob believes the business can be sold for $875,000 after taxes (disposal value) at the end of its 20-year life. Using a 11.25% required return, what is the net present value of this venture?
Please rework the prior problem to determine what annual sales volume is needed to generate a net present value of $0? It may be beneficial to review the textbook problem and video.
