Introduction to Corporate Finance

11: Risk and Capital Budgeting

A Subtle Decision Tree Issue

There is a subtle flaw in our analysis of Russian Foods. Can you spot it? Currently, when Russian Foods

must decide whether or not to invest in test marketing, it does not know what the test results (unavailable

for another year) will indicate. So at the end of one year, when the company chooses whether or not to

invest $50 million for a major product launch, it will know a great deal more. If the market research in

Perth indicates a high demand for Odessa, then the risk that it will flop elsewhere in Australia is probably

very low. If so, does it make sense to use a discount rate of 15% when calculating the NPV of the product

launch decision? A mere one-percentage point reduction in the discount rate, from 15% to 14%, would

be enough to cause the expected NPV of conducting the market test to increase from –$0.55 to $0.52,

thereby suggesting that Russian Food’s test marketing would be worthwhile.

This insight leads us to consider the use of real options in making present-value calculations, and to

accommodate the observation that we learn about risks and outcomes for the future as we go through a

project. This is covered in the next section.

FIGURE 11.3 DECISION TREE FOR ODESSA INVESTMENT

The decision tree depicts the sequence of decisions facing Russian Foods’ decision whether to spend $5 million
to test market Odessa, a new salt substitute. If the test market is successful, the NPV of launching the product is $10.23
million; if the initial test results are negative, and it launches the product, it will have an NPV of −$39.96 million. By
working backwards (from right to left on the tree), Russian Foods can decide whether to conduct the test in the first place.

Spend

$5 million?

Test

High demand

(probability = 50%)

Launch

Launch

Do not launch

Do not launch

Low demand

(probability = 50%)

NPV = –$39.96 million

NPV = $10.23 million

NPV = $0

NPV = $0

Do not test

5 Why might a project that reaches the breakeven point (BEP) in terms of net income be bad for

shareholders?

6 Which variable do you think would be more valuable to examine in a project sensitivity analysis:

the growth rate of sales or the allowable depreciation deductions each year? Explain.

7 Why might the discount rate vary as you move through a decision tree?

CONCEPT REVIEW QUESTIONS 11-2