Yoran Yacht Company (YYC), a prominent sailboat builder in Victoria, B.C., is considering designing a new 30-foot sailboat based on the "winged" keels first introduced on the 12-metre yachts that raced for the America's Cup.
First, YYC would have to invest $10,000 at t = 0 for the design and model tank testing of the new boat. YYC's managers believe that there is a 60% probability that this phase will succeed and that the project will continue. If Stage 1 is not successful, the project will be abandoned with zero salvage value.
The next stage, if undertaken, would consist of making the moulds and producing two prototype boats. This would cost $500,000 at t = 1. If the boats test well, YYC would go into production. If they do not, the moulds and prototypes could be sold for $100,000. The man- agers estimate that the probability is 80% that the boats will pass testing and that Stage 3 will be undertaken.
Stage 3 consists of converting an unused production line to produce the new design. This would cost $1,000,000 at t = 2. If the economy is strong at this point, the net value of sales would be $3,000,000, while if the economy is weak, the net value would be $1,500,000. Both net values occur at t = 3, and each state of the economy has a probability of 0.5. YYC's corporate cost of capital is 12%.
a. Assume that this project has average risk. Construct a decision tree and determine the project's expected NPV.
b. Find the project's standard deviation of NPV and coefficient of variation (CV) of NPV. If YYC's average project had a CV of between 1.0 and 2.0, would this project be of high, low, or average stand-alone risk?