Question

You are trying to decide whether to make an investment of

$498.7million in a new technology to produce Everlasting Gobstoppers. There is a

61% chance that the market for these candies will produce profits of

$98.9 million​ annually, a(n)

22% chance the market will produce profits of$50.1

​million, and​ a(n) 17% chance that there will be no profits. The size of the market will become clear one year from now.​ Currently, the cost of capital of the project is

11.47%per year. There is​ a(n) 21%chancethat the cost of capital will drop to8.86%in a year and stay at that level​ forever, and​ a(n)79% chance that it will stay at

11.47% forever. Movements in the cost of capital are unrelated to the size of the candy market. Construct the decision tree that shows the choices you​ have: to make the investment either today or one year from now. What decision should you make if the​ one-year cost of capital is15.59%and the profits last​ forever?

Answer 1

The above decision tree states that there is a 13% probablity (61% * 21%) that the return will be 553.42 and a 48% probability( 61%*79%) that the return will be 540.4.

Only in these two cases the return is higher than making an investment one year later. But the probablitiy of the return is less than 50%, thus it is preferable for a conservative investor to invest one year later.