Question

3. Edward’s Cinema operates a multiplex cinema that has nine small theaters in one building. Business has been good lately and management is considering a project that will add five screens at an estimated cost of $4 million. The success of the expansion depends on whether local demand over the next two years will support the additional capacity. Demand is believed to depend on the local economy. An economist at a California State University at Bakersfield has predicted a 80% probability of continued prosperity in the area and a 20% chance of a moderate downturn. Management feels that if prosperity continues the new theaters will generate a profit margin of $3 million in the first year and $4 million in the second. A moderate downturn would produce contributions of $1.5 and $2 million. Edward’s Cinema’s cost of capital is 12%.

a. Draw a decision tree for the project. b. Calculate the NPV along each path. Path 1 _____________________________________________________________________ Path 2 _____________________________________________________________________

c. Develop the probability distribution of the project’s NPV. NPV Probability ____________ ________ ____________ ________

d. Calculate the project’s expected NPV. _________________________________________________________________________________________________________________________________________________________________________________________________________________________________ e. Make a recommendation on the project with an appropriate comment on risk. ____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

Answer 1

1) Decision Tree

			In case of continued prosperity
		80%	Year 1	Year 2
Year 0 (Initial Investment)			3000000	4000000
-4000000
			In case of moderate downturn
		20%	Year 1	Year 2
			1500000	2000000

2) NPV in both cases

Cost of Capital	12%
Cashflows	Year 0	Year 1	Year 2	NPV
In case of continued prosperity	-4000000	3000000	4000000	1667274.05
In case of moderate downturn	-4000000	1500000	2000000	-952077.26

3) Probablity distribution for projects NPV

Case	Probablity	NPV	Expected Weighted NPV
In case of continued prosperity	80%	1667274.05	1333819.2
In case of moderate downturn	20%	-952077.26	-190415.5
Expected NPV of project			1143403.8

4) Expecyed NPV is 1143403.8 as shown and explained above