LINEAR REGRESSION FORECASTING AND DECISION TREES
Scenario: Using the situation from SLP2, recall that you are deciding between two investments. However, they each require a different initial investment amount. And you also have a third option, to invest in a 10 year municipal bond with a very high return. Here are the investment options with the augmented data.
Option A: Real estate development. This is a risky opportunity with the possibility of a high payoff, but also with no payoff at all. You have reviewed all of the possible data for the outcomes in the next 10 years and these are your estimates of the Net Present Value of the cash flow and probabilities.
Required initial investment: $0.75 million
High NPV: $5 million, Pr = 0.5
Medium NPV: $2 million, Pr = 0.3
Low NPV: $0, Pr = 0.2
Option B: Retail franchise for Just Hats, a boutique type store selling fashion hats for men and women. This also is a risky opportunity but less so than option A. It has the potential for less risk of failure, but also a lower payoff. You have reviewed all of the possible data for the outcomes in the next 10 years and these are your estimates of the Net Present Value of the cash flow and probabilities.
Required initial investment: $0.55 million
High NPV: $3 million, Pr = 0.75
Medium NPV: $2 million, Pr = 0.15
Low NPV: $1 million, Pr = 0.1
Option C: High Yield Municipal Bonds. This option has low risk and is assumed to be a Certainty. So there is only one outcome with probability of 1.0 Required initial investment: $0.75 million NPV: $1.5 million, Pr = 1.0
Develop an analysis of these three investments. Use expected NPV to determine which of these you should choose. Be sure to include all cash flows to generate the total NPV of each alternative. Do your analysis in Excel using decision tree.
Write a report to your private investment company and explain your analysis and your recommendation. Provide a rationale for your decision.
Upload both your written report and Excel file with the decision tree analysis to the SLP 3 Dropbox.
BONUS (2.0 pts): If the two options A and B could be made to be equal, what would have to change in the NPVs in Option A to make it equal to Option B?
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