Suppose Kumalo Entertainment must decide whether to expand by building a few large theaters in large cities or building a number of mini theaters in small towns. Each of the alternatives would require an initial investment of $1 million. Although the large theaters have a greater expected return, the option has greater risk because there is more competition in the large cities. In contrast, there is less potential for profit in the small markets, but in many of them there is little or no competition. The expected values of the net cash flows in each of the next 7 years are $300,000 per year in the large markets and $250,000 per year in the small markets. The CV=1.5 for the large markets and 1.0 for the small markets. If 18% would be used to discount cash flows in the large-city alternative and a rate of about 10% to discount cash-flows in the small-city alternative, which between the two should the company invest into?

Solution: Use the appropriate risk-adjusted discount rate in each alternative and compute the NPV. Large-city alternative: