Question

Tom Wilson is the operations manager for BiCorp, a real estate investment firm.  Tom must decide if BiCorp is to invest in a strip mall in a northeast metropolitan area.  If the shopping center is highly successful, after tax profits will be $100,000 per year.  Moderate success would yield an annual profit of $50,000, while the project will lose $10,000 per year if it is unsuccessful.  Past experience suggests that there is a 40% chance that the project will be highly successful, a 40% chance of moderate success, and a 20% probability that the project will be unsuccessful.
The project requires an $800,000 investment.  If BiCorp has an 8% opportunity cost on invested funds of similar riskiness, should the project be undertaken?

Answer 1

If shopping center is highly successful, profit will be $100,000. The probability of project being highly successful is 40%.

If shopping center is mederately successful, profit will be $50,000. The probability of project being moderately successful is 40%.

If shopping center is unsuccessful, loss will be $10,000. The probability of project being unsuccessful is 20%.

Calculate the expected profit -

Expected profit = [profit when project is highly successful * probability of highly successful] + [profit when project is moderately successful * probability of moderately successful] + [loss when project is unsuccessful * probability of unsuccessful]

Expected profit = [$100,000 * 0.40] + [$50,000 * 0.40] + [-$10,000 * 0.20]

Expected profit = $40,000 + $20,000 - $2,000

Expected profit = $58,000

The annual expected profit is $58,000

The project will have the infinite life.

Calculate the present worth -

PW = -Initial investment + Annual expected profit (P/A, i, n)

PW = -$800,000 + $58,000(P/A, 8%, )

PW = -$800,000 + [$58,000/0.08]

PW = -$800,000 + $725,000

PW = -$75,000

The present worth of the project is -$75,000.

A project with negative present worth is unviable and should not be undertaken.

Thus,

The project should not be undertaken.