Question

Free Spirit Industries Inc. is planning to add a new product line to make iToys. However, Free Spirit Industries Inc. is considering the possibility of abandoning the project if the demand for the new product is low. In the following decision tree table, (1), (2) and (3) represent decision points, also known as decision nodes or stages. The dollar value to the right of each decision node represents the net cash flow at that point, and the cash flows shown under t = 3, 4, and 5 represent the cash inflows if the project is pushed on to completion. If Free Spirit Industries Inc. decides to launch the new line for iToys at Stage (1), then it will spend $20,000 on the marketing study. If the marketing study yields positive results, then the firm will spend $100,000 on the prototype. If the prototype works well, then the firm will spend several millions more at Stage (3) to build a production plant. Suppose that as an analyst at Free Spirit Industries Inc. you have to analyze sequential decisions. By studying the following decision tree, you learn which of the following? Check all that apply. There is a 15% probability that the marketing study will produce negative results. There is a 10% probability of the pilot project yielding average results. There is a probability of 85% that the marketing study will produce positive results. There is a 15% probability that the marketing study will produce positive results. Complete the decision tree table by calculating the net present values (NPVS) and joint probabilities, as well as products of joint probabilities and NPVs for each decision branch. Assume that the weighted average cost of capital (WACC) is 10% for all decision branches. Hint: Use either a spreadsheet program's functions or a financial calculator for this task. Round the NPVs to the nearest dollar and remember to enter the minus sign if a value is negative. Note: All cash amounts in the following table are in thousands of dollars. Step 0 Step 1 1st Invest Prob 2nd Invest Step 2 3rd Invest Step 3 Inflow Step 4 Inflow Step Step 5 Inflow Step, 5 MPY Prob NPV ($) Joint Prob (%) NPV x Joint Prob ($) 85% -$100 (2) 50% (2) 40% (2) 10% -$10,269 -$10,000 Stop $0 (3) $4,761 (3) $1,900 (3) $0 $0 $8,237 $2,345 $0 $0 $20,065 $7,800 $0 $0 (1) -$20 15% Stop Expected NPV = Based on your calculations, in case Free Spirit Industries Inc. abandons the new project right after the marketing study, the loss is $100,000 $100,000 $171,000 $503,000 $20,000

Answer 1

As an analyst, you are calculating the financial outcomes of launching an iToy product line using a decision tree with NPVs and probabilities. An 85% chance exists for a positive marketing study, and the immediate loss after an abandoned marketing study is $20,000. The detailed NPV calculations are needed for precise financial planning.

Step-by-step explanation:

Your task as an analyst at Free Spirit Industries Inc. involves analyzing sequential decisions using a decision tree, which helps determine the financial viability of launching a new iToy product line. From the question, we understand the following:

• There is an 85% probability that the marketing study will produce positive results.
• There is a 15% probability that the marketing study will produce negative results.

However, there is a conflicted point in the question stating both a 15% and 85% probability for positive results, it seems like a typo, and you should proceed with the consistent information; therefore, the 15% probability for positive results is most likely incorrect.

You are asked to complete a table with net present values (NPVs), joint probabilities, and products of joint probabilities and NPVs for each decision branch, using a 10% WACC. The expected NPV calculation will help determine the expected loss or gain across different outcomes of the project. Since the question doesn't provide specific cash inflow numbers, one cannot calculate the exact NPV values.

In conclusion, the initial loss if the project is abandoned after the marketing study would be the $20,000 spent on the study. Further losses or gains would depend on the progress and outcomes at each subsequent stage.