Question

Racquet Centers, Inc. (RCI) is a small investment company. The company is considering building a new racquet center. If the demand for the center is high (i.e., there is a favorable market for the racquet center), RCI could realize a net profit of $100,000. If the market is not favorable, RCI could lose 40,000. Of course, they don't have to proceed at all; in which case, there is no cost. In the absence of any market data, the best RCI can guess is that there is a 50-50 chance the center will be successful. Construct a decision tree to help analyze this problem. What should RCI do? Please show your decision tree, Excel computations, and fully explain your answer.

Answer 1

RCI should use a decision tree to assess the outcomes of building a new racquet center, considering the profits and losses under different market conditions, and whether variable costs are covered by revenues.

Step-by-step explanation:

Racquet Centers, Inc. (RCI) is evaluating the possibility of building a new racquet center and needs to make a decision based on potential profitability. To assist with this decision, a decision tree can be constructed to visualize the possible outcomes. With a 50-50 chance of market success, the decision tree would have two branches from the initial decision node: one for the scenario where the demand is high, and RCI would realize a net profit of $100,000, and another for the scenario where the demand is low, leading to a $40,000 loss .In the case where the racquet center earns revenues of $20,000 with variable costs of $15,000, the decision would lead to the center continuing its operations, as it can cover its variable costs and generate a contribution margin. However, if the revenues are $10,000 with the same variable costs, the firm should shut down immediately to avoid further losses since it cannot cover the variable costs. This immediate shutdown would minimize losses to just the fixed costs. For the long-run decision-making, if revenues do not improve, RCI should not renew their rental contracts and exit the business. In the short term, the decision to stay open or shut down depends on whether variable costs are covered by the revenues.