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A building supply store is considering expanding its capacity to meet a
growing demand for its products. The alternatives are to build a new
store at a site nearby, expand the existing store, or do nothing. There
is a 60% chance the economy will be stable, and a 20% chance of either
an economic upturn or downturn. The following NPV estimates based on
economic conditions have been provided: Build new store Expand old store
Do nothing Market upturn (millions) $1.9 $1.5 $0.5 Stable market
(millions) $0.3 $0.5 $0.0 Market downturn (millions) -$0.5 -$0.3 -$0.1
a. Set up a decision-tree for this problem b. What should the company
do?
2. You can acquire an existing business for $2 million. You are
uncertain about future demand. There is a 40% chance of high demand, in
which case the present value of the business will be $3 million. There
is a 25% chance of moderate demand, and the associated present value is
$1.5 million. Finally, there is a 35% chance of low demand, in which
case the present value is $1 million. Draw a decision tree for this
problem. What is the expected net present value of the business? Should
you invest? Explain.
3. Suppose that if you buy the business described
in Question 2, you can expand the business by investing another $500,000
(total investment would be $2.5 million) after you learn the true
future demand state. This would make the present value of the business
$4 million in the high- demand state, $2.5 million in the moderate
demand state, and $1.0 million in the low demand state. Draw a decision
tree to reflect the option to expand. Evaluate the alternatives. What is
the net present value of the business if you consider the option to
expand? How valuable is the option to expand?
4. Consider Question 2
again and suppose that the market value of the business assets would
have a present value of $1.8 million if the business were to be
liquidated after the true demand state is known. Draw a decision tree to
reflect the abandonment option. Evaluate the alternatives. What is the
net present value of the business if you consider the abandonment
option? How valuable is the option to abandon?
5. Finally, reevaluate
the investment opportunity in Question 2, incorporating both the
expansion opportunity from Question 3 and the abandonment option from
Question 4. Draw the decision tree incorporating both options. Are the
values of the expansion and abandonment options additive? Why or why
not?

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