Introduction to Corporate Finance

PART 3: CAPITAL BUDGETING

leading to a lower market share and a lower selling price than originally anticipated? If production volume

falls short of expectations, cost as a percentage of sales may also be higher than expected.

11-2d DECISION TREES

Most important investment decisions are much more complex than simply forecasting cash flows,

discounting at the appropriate rate, and investing if the NPV exceeds zero. In the real world, managers face

a sequence of future decisions that influence an investment’s value. These decisions might include whether

to expand or abandon a project, whether to alter a marketing program, when to upgrade manufacturing

equipment and, most important, how to respond to the actions of competitors. A decision tree is a visual

representation of the sequential choices that managers face with regard to a particular investment.

Sketching out a decision tree is somewhat like thinking several moves ahead in a game of chess. The value

of decision trees is that they force analysts to think through a series of if ... then statements that describe

how they will react as the future unfolds. The following example illustrates the use of decision trees.

example

Imagine that Russian Foods Ltd of Western Australia

has invented a new salt substitute, Odessa, which it

plans to use in snack foods such as potato chips and

crackers. The company is trying to decide whether to

spend $5 million to test-market, in Perth, a new line

of potato chips flavoured with Odessa. Depending on

the outcome of that test, Russian Foods may spend an

additional $50 million one year later to launch a full line

of snack foods across Australia. If consumer acceptance

in Perth is high, the company predicts that its full

product line will generate net cash inflows of $12 million

per year for 10 years.^5 If consumers in Perth respond less

favourably, Russian Foods expects cash inflows from a

nationwide launch to be just $2 million per year for 10

years. Russian Food’s cost of capital is 15%.

Figure 11.3 shows the decision tree for this problem.

Initially, the company can choose whether or not to spend

the $5 million on test marketing. If Russian Foods goes

ahead with the market test, it estimates the probability of

high and low consumer acceptance to be 50%. After the

company sees the test results, it will decide whether to

invest $50 million for a major product launch.

The proper way to work through a decision tree is

to begin at the end and work backward to the initial

decision. Suppose that Russian Foods learns one year

from now that the Perth market test was successful.

At that point, Russian Foods calculates the NPV (in

millions of dollars) of launching the product as follows:

=− +++⋅⋅⋅+

=

NPV $50+

$12

1.15

$12

1.15

$12

1.15

$12

1.15

$10.23

12310

Clearly, Russian Foods will invest if it winds up

in this part of the decision tree. But what if initial

test results are unfavourable and it still launches the

product? In that situation, the NPV is as follows:

=− +++⋅⋅⋅+

=−

NPV $50+

$2

1.15

$2

1.15

$2

1.15

$2

1.15

$39.96

12310

Thus, the product should not launch if the test

marketing is unfavourable. The best decision to make

if the initial test does not go well is to walk away. After

the test has been done, its cost is a sunk cost. As of

time 1, the NPV of doing nothing is zero.

A decision tree helps to create a set of simple if ...

then decision rules. If initial test results indicate high

consumer acceptance of Odessa, then Russian Foods

should go ahead with the full product launch to capture

a positive NPV of $10.23 million. But if initial results show

that consumers do not like foods flavoured with Odessa,

Russian Foods should not invest the additional $50 million.

With this information in hand, we now step back and

evaluate the project at time 0. We can evaluate today’s

decision about whether or not to spend the $5 million

on testing. Recall that we calculated the NPVs in terms

of year-1 dollars – that is, as of the date of the decision

on whether or not to launch the product nationwide. In

terms of today’s dollars (millions), the expected NPV of

conducting the market test is determined to be:

=− +









+









NPV $5 0.5 =−

$10.23

1.15

0.5

$0

1.15

$0.55

Spending the money on test marketing does not

appear to be worthwhile.

LO11.4

See the concept explained

step by step on the

CourseMate website.

SMART

CONCEPTS

Pam Roberts, former

Executive Director of

Corporate Services,

Cummins Inc.

‘We recognise that

we can’t predict each

parameter with great

accuracy.’

See the entire interview on

the CourseMate website.

COURSEMATE
SMART VIDEO

Source: Cengage Learning

5 Note that the test begins immediately, the $50 million investment starts one year later and the stream of $12 million annual cash inflows

begins one year after that.

decision tree

A visual representation of

the sequential choices that

managers face with regard to

a particular investment