10. Vaughn Video is considering refurbishing its store at a cost of $1.4 million.

Management is concerned about the economy and whether a competitor, Viola Video, will open a store in the neighborhood. Vaughn estimates that there is a 60% chance that Viola will open a store nearby next year. The state of the economy probably won’t affect Vaughn until the second year of the plan. Management thinks there is a 40% chance of a strong economy and a 60% chance of a downturn in the second year. Incremental cash flows are as follows:

Year 1:

Viola opens a store—$700,000 Viola doesn’t open a store—$900,000 Year 2:
Viola opens a store, strong economy—$850,000 Viola opens a store, weak economy—$700,000 Viola doesn’t open a store, strong economy—$1,500,000 Viola doesn’t open a store, weak economy—$1,200,000 Perform a decision tree analysis of the refurbishment project. Draw the decision tree diagram, and calculate the probabilities and NPVs along each of its four paths. Then calculate the overall expected NPV. Assume that Vaughn’s cost of capital is 10%.