Question: Douglas Rockwell (DR), a local defense company specializing in rotorcraft blades, is considering entering the autonomous air vehicle (UAV) market. The Army is offering a $20 million UAV five year research program that will lead to a competition for a $250 million ten year UAV production program. To provide the resources for the research program, DR will need to shut down its rotorcraft blade manufacturing work.
Therefore, the company needs to decide, before bidding on the research program, whether it is willing to shut down the rotorcraft business on the chance that it can win the production program.
Your job is to determine the NPV of three alternative futures, put them in a decision tree, and decide what path to take.
Future scenario 1 - Stay with the rotorcraft business:
Year 0 investment = 0
Annual operation, year 1 to 50: $7 million revenue, $4 million cost, $1.5 million expenses
Future scenario 2 - Change to UAV business and win the production contract.
Year 0 investment:
$20 million for new production plant ($2 million for land, $7 million for building, $11 million for manufacturing equipment
$5 million of computer equipment for verification test laboratory
Annual operation Year 1 to 5 (research program): $4 million revenue, $3 million research expense (no tax credits)
Annual operation Year 6 to 15 (production program): $25 million revenue, $12 million cost, $3 million expense
Annual operation Year 16 to 50 (maintenance): $15 million revenue, $5 million cost, $3 million expense
Future scenario 3 - Change to UAV business but lose the production contract.
Year zero investment and Year 1 to 5 operation are the same as Future scenario 2
Annual operation Year 6 to 50 (shut down): 0 revenue, 0 cost, 0 expense
Note: DR's discount rate is 12%. The probability of winning the production contract is only one-third. Depreciation continues throughout the shutdown until investments are fully depreciated.