Question

Allison’s Dresswear Manufacturers is preparing a strategy for the fall season. One alternative is to expand its traditional ensemble of wool sweaters. A second option would be to enter the cashmere sweater market with a new line of high-quality designer label products. The marketing department has determined that the wool and cashmere sweater lines offer the following probability of outcomes and related cash flows.
  

	Expand Wool Sweaters Line							Enter Cashmere Sweaters Line
Expected Sales	Probability			Present Value of Cash Flows from Sales				Probability			Present Value of Cash Flows from Sales
Fantastic		.3		$	201,000				.2		$	327,000
Moderate		.6			165,000				.5			232,000
Low		.1			91,800				.3			0

The initial cost to expand the wool sweater line is $161,000. To enter the cashmere sweater line, the initial cost in designs, inventory, and equipment is $155,000.
  
a. Calculate net present value if, Allison’s Dresswear Manufacturers decides to: Expand wool sweaters line; OR; Enter cashmere sweaters line (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Round your answers to the nearest whole dollar.)
  

  

Answer 1

We need to calculate the NPV of two projects, and the one with higher NPV adds maximum value to firm and hence should be selected.

NPV = PV (Cash inflows) - PV (Cash out flows)

In order to calculate the PV of cash inflows, we need to calculate the expected value of each, which is weighted average cash flows, weighted by probability. Expected cash inflow for each option is:

E[Wool] = 60,300 + 99,000 + 9,180 = $168,480

PV of Wool expansion = 168,480 - 161,000 = $ 7,480

E[cashmere] = 65,400 + 116,000 + 0 = $181,400

PV of Cashmere = 181,400 - 155,000 = $ 26,400

Given NPV is higher for entering Cashmere line, that option should be selected