Question 1

Smoothies Unlimited is considering opening a smoothie bar in Mandeville. The first

expenditure is the $25,000,000 investment required to retrofit the location. Based on the

analysis, the probabilities are 0.25 that it will be extremely popular, 0.60 that it will be

moderately successful and 0.15 that it will not perform well.

If the smoothie bar is extremely popular, operating cash flows of $10 million at the end

of years 1, 2 and 3 will be expected. In that case, the company will expand the

business at the end of year 3 at a cost of $8,000,000. After the expansion, the

probabilities are 0.75 that the subsequent operating cash flows at the end of year 3 will

be $16,000,000 , 0.25 that they will be $10,000,000. Each of these cash flow streams

would continue in years 4 to 8.

If the smoothie bar is moderately successful, operating cash flows of $6 million per year

at the end of years 1 through 8 are expected.

If the smoothie bar is does not perform well, cash flows are expected to be $2,000,000

per year over the 8-year life of the project. If this is the case, Raw Foods will close the

smoothie bar at the end of the second year. $8 million of the original investment would

be recovered.

a) Draw a decision tree showing the decisions, outcomes and probabilities associated

with the new project. [5 marks]

b) Calculate the joint probability and NPV of each path of decision tree. Assume the

required rate of return is 17%. [20 marks]

c) Calculate the expected NPV of the entire project. [4 marks]

d) What is the value of the abandonment option? [3 marks]

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e) Should the firm undertake the project?