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Net Present Value Under Base Case and Alternative Case

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Scenario Analysis: Estimated Cash Flows for the Segway People Mover

BaseCase Year0 Year1-12 BicycleScenario Year0 Year1-12
Investment -5400 Investment -5400
Sales 16000 Sales
Variable Costs 13000 Variable Costs
Fixed Costs 2000 Fixed Costs
Depreciation 450 Depreciation
Pretax profit 550 Pretax profit
Taxes @40% 220 Taxes @40%
Profit after tax 330 Profit after tax
Operating cash flow 780 Operating cash flow
Net cash flow -5400 780 Net cash flow -5400

NPV(OCCof 9%): $185.37 NPV(OCCof 9%): --

Consider the scenario in which a competing form of transportation, the bicycle, causes sales to drop to 90% of expected sales from the base case.

a. Fill in the table on the right, including NPV

b. What is maximum opportunity cost of capital in both the Base Case and the Bicycle Scenario such that you should undertake the Segway People Mover Project?

In excel format.

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Solution Summary

This solution illustrates how to adjust revenues and expenses for alternative scenarios and how to compute the project's net present value under its base case and alternative scenario. It also illustrates how to compute the maximum opportunity cost of capital at which the company should undertake the project. All computations are done in Excel with Excel functions.

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NPV Investment Opportunity

Scenario: You are an entrepreneur that has several business investments in real estate, restaurants, and retail stores. You are looking for your next investment opportunity for you and your private equity investment company. You have found two possible alternatives to invest in that will payoff in the next 10 years. Here are the descriptions of the two options.
Option A: Real estate development. This is a risky opportunity with the possibility of a high payoff, but also with no payoff at all. You have reviewed all of the possible data for the outcomes in the next 10 years and these are your estimates of the Net Present Value of the cash flow and probabilities.
High NPV: $5 million, Pr = 0.5
Medium NPV: $2 million, Pr = 0.3
Low NPV: $0, Pr = 0.2
Option B: Retail franchise for Just Hats, a boutique type store selling fashion hats for men and women. This also is a risky opportunity but less so than option A. It has the potential for less risk of failure, but also a lower payoff. You have reviewed all of the possible data for the outcomes in the next 10 years and these are your estimates of the Net Present Value of the cash flow and probabilities.
High NPV: $3 million, Pr = 0.75
Medium NPV: $2 million, Pr = 0.15
Low NPV: $1 million, Pr = 0.1
Develop an analysis of these two investments. Use expected value to determine which of these you should choose. Do your analysis in Excel.
Write a report to your private investment company and explain your analysis and your recommendation. Provide a rationale for your decision.
BONUS: If these two options could be made to be equal, what would have to change in the payoffs in Option A to make it equal to Option B (not the investment amount)?
• Accurate and complete analysis in Excel.
Written Report
• Length requirements = 2-3 pages minimum (not including Cover and Reference pages)
• Provide a brief introduction/ background of the problem.
• Complete and accurate Excel analysis.
• Written analysis that supports Excel analysis, and provides thorough discussion of assumptions, rationale, and logic used.
Complete, meaningful, and accurate recommendation(s).

One of the biases that has been proposed by Kahneman and Tversky and researched a great deal is the Availability bias. What is the Availability bias? How might it play a role in the decision in SLP 2? Consider that the estimated probabilities for both of the High NPV future states are relatively high (0.50 and 0.75). How could the Availability bias be at work here? How could using objective data analysis like frequency distributions mitigate the effect of the Availability bias?

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