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NPV Investment Opportunity

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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
Requirement
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)?
Expectations
Analysis
• 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).

SEPERATE DISCUSSION:
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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Solution Summary

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.

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Probability Question - NPV

Expected NPV
Expected net present value is a capital budgeting technique which adjusts for uncertainty by calculating NPVs under different scenarios and probability-weighting them to get the most likely NPV.
For example, instead of relying on a single NPV, companies calculate NPVs under a range of scenarios; say base case, worst case and best case. They then estimates probability of occurrence of each scenario and then weight the NPVs calculated according to their relative probabilities to find the expected NPV.
Expected NPV is a more reliable estimate than the traditional NPV because it considers the uncertainty inherent in projecting future scenarios.

Formula
Expected NPV is the sum of the product of NPVs under different scenarios and their relevant probabilities. The following formula is used to calculate expected NPV.
Expected NPV = Σ (p × Scenario NPV)
Scenario NPV is the NPV under a specific scenario ...

Solution provided by:
Chris Busu, PhD (IP)
Education
  • BSc, University of Bucharest
  • MSc, Ovidius
  • MSc, Stony Brook
  • PhD (IP), Stony Brook
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