As a marketing manager for a large sports apparel manufacturer, you are trying t
ID: 2752737 • Letter: A
Question
As a marketing manager for a large sports apparel manufacturer, you are trying to decide whether to open a new factory outlet store, which would cost about $500,000. Success of the outlet store depends on demand in the new region. If demand is high, you expect to gain $1 million per year; if average, $500,000; and if low, to lose $80,000. From your knowledge of the region and your product, you feel the chances are 0.4 that sales will be average, and equally likely that they will be high or low (0.3, respectively). Assume that the firm’s MARR is known to be 15%, and the marginal tax rate will be 40%. Also, assume that the salvage value of the store at the end of 15 years will be about $100,000. The store will be depreciated under a 39-year property class.
(a) If the outlet store will be in business for 15 years, should you open the new outlet store? How much would you be willing to pay to know the true state of nature?
(b) Suppose a market survey is available at $1,000 with the following reliability, values obtained from past experience where actual demand (State) was compared with predictions made by the market survey(Suggestion).
Determine the strategy that maximizes the expected payoff after taking the market survey. Assume that you are a risk-neutral person so that you are interested in maximizing the expected monetary value.
(c) What are the three methods of describing project risks? Briefly describe each of them.
Actual Demand Given Production Survey Low Medium High Low 0.75 0.2 0.05 Medium 0.2 0.6 0.2 High 0.05 0.25 0.7Explanation / Answer
Calculation of cash flows of each year Success Probability Cash inflows Expected cash inflows ( Cash inflows * Probability ) High 0.3 $1,000,000 $300,000 Average 0.4 $500,000 $200,000 Low 0.3 $80,000 $24,000 Total $524,000 a Calculation of net present values Year Expected cash inflows Depreciation ( Note 1 ) Cash inflows after depreciation( Expected cash inflows - Depreciation ) Tax amount @ Cash inflows after tax amount ( Cash flows after depreciation - Tax amount) Net cash flows ( Cash inflows after tax amount + Depreciation ) Present vale Cumulative discount factor ( Note 2 ) Present value of cash inflows( Net cash inflows * Present value discount factor ) 1 to 15 $524,000 $10,256 $513,744 $205,497 $308,246 $318,503 5.8473 $1,862,380 Present residual value of the shop = 100000 * Present value of discount factor at 15 % of the 15 th year ( Note 2 ) Present residual value of the shop = 100000* 0.1228 Present residual value of the shop = $12,280 Total present value of cash inflows = Present vale of cash inflows of 15 years + Present value of residual value of 15th year ( Note 2 ) Total present value of cash inflows = 1862380 + 12280 Total present value of cash inflows = $1,874,660 Present value of cash outflows = $500,000 Net present value = Present value of cash inflows - Present value of cash outflows Net present value = 1874660 - 500000 Net present value = $1,374,660 Decision Since the net present value is positive the shop can be opened. The amount of 1874660 can be paid to purchases the shop, as at this stage the company will not earn any loss or incurred any loss. Note 1 Calculation of depreciation Cost of the shop = $500,000 Residual value = $100,000 Number of years of depreciation = 39 Depreciation = Cost - residual value / Number of years of asset depreciation Depreciation = (500000-100000)/39 Depreciation = $10,256 Note 2 Present value cumulative discount factor at 15% for 15 years Present value discount factor = 5.8473 Present value of discount factor at 15 % of 15th year = 0.1228 b Determine the strategy that maximizes the expected payoff after taking the market survey. Actual Demand Given Production Survey Total Low Medium High Low 0.75 0.2 0.05 Cash flows $80,000 $500,000 $1,000,000 Expected cash inflows ( Probability * Cash inflows ) $60,000 $100,000 $50,000 $210,000 Medium 0.2 0.6 0.2 Cash flows $80,000 $500,000 $1,000,000 Expected cash inflows ( Probability * Cash inflows ) $16,000 $300,000 $200,000 $516,000 High 0.05 0.25 0.7 Cash flows $80,000 $500,000 $1,000,000 Expected cash inflows ( Probability * Cash inflows ) $4,000 $125,000 $700,000 $829,000 Alternatives Total payoffs Low $210,000 Medium $516,000 High $829,000 Decision The strategy of high is giving more total payoffs, and it is better strategy alternative.
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