Case Scenario: Valuing a project with exit opportunities
You are contemplating establishing a central Orlando coffee bar. You can sell coffee for $2.20 a cup. Demand is uncertain: it could be low in which case you will sell 12,000 cups of coffee per year, or it could be high, in which case you will sell 17,000 cups per year. Demand is known only at the end of the year (when there is demand uncertainty, it is impossible to tell at the start of the year how it will resolve itself). The first year demand will be low with probability 0.4 and high with probability 0.6. If the demand starts high then there is 0.5 probability at the end of the first year that it will become low in the following years; if it starts low then it remains low in the following years. After this demand will not change again. The fixed running costs for the business are $15,000, irrespective of demand levels. You have to choose between two different espresso machines. Machine 1 costs $5,500 and will result in a marginal cost of $.85 per coffee; machine 2 costs $11,000 and will result in a marginal cost of $.55 per coffee. (Marginal costs expressed here include non-coffee costs such as labor). Both machines have an economic life of five years. You can leave the business costlessly at the end of any year when the second hand value of the espresso machine will be zero. Assume that the appropriate discount rate is 20%.
Using decision trees, decide whether you should enter the coffee bar business, and if so, which machine you should buy.