Reference no: EM132941854

The Tall Oaks Wood Products Company is considering purchasing timberland for $5 million that would provide a future source of timber supply for the company's operations over the next 10 years. Alternatively, for $5 million, the company could also buy timber as needed on the open market. The future cash flows from using the timber are estimated to have a present value of $6 million regardless of whether the company buys the timberland today or waits to purchase its timber as needed over the next 10 years. This means there is a $1 million net present value (NPV) of either buying the timberland now or buying the timber as needed. In other words, from a financial standpoint, the two alternative timber acquisition strategies would be equal. Now suppose, that the company believes there is only a 60% chance that the environmental regulations affecting timber supply will remain unchanged. Furthermore, the company believes that there is a 30% chance these regulations will become stricter during the next 10 years and only a 10% chance that these regulations will be relaxed. A reduction in timber supply should cause an increase in both the present value of future cash flows from using the timber due to higher sales prices and an increase in the present value of the cost of purchasing the timber as needed. (Of course, the change in selling price and buying cost may not be equal.) Should regulations become stricter, the company believes the NPV from buying the timberland now would increase to $1.5 million while an NPV of buying the timber as needed would decrease to -$0.50 million. Increases in the timber supply should have the opposite effects. Thus, should regulations become less strict, the company believes the NPV from buying the timberland now would decrease to -$0.5 million while an NPV of buying the timber as needed would increase to $1.50 million.

a. Construct a payoff matrix for this problem.