Question: Assume that the federal government just announced plans to build a new embassy in France, and is asking individuals in the architectural community to submit design proposals. The 5 best entries will be awarded $25,000 immediately, and the best entry will receive a contract that will result in net before-tax income of $50,000 for each of the 3 following years. Of the remaining 4 best designs, I is likely to be chosen by a provincial government that is currently planning to build a new Centre of Trade and Commerce in New York. This project will have identical 3-year cash flows, except that they will start I year later. A well-established firm of architects is considering whether to submit a proposal, and has asked you to help them to decide how much they should spend on the preliminary design. They realize that the more time and effort they put into the proposal the more likely they are to be awarded a contract. On the other
hand, the more time they spend on the preliminaries, the less they will profit if they get a contract, and the more they will lose if they don't. The firm is considering 3 different preliminary design packages and has come up with the following table:
All preliminary costs are expensed, and all subsequent income is taxed in the year that it arises. The tax rate is 40 percent and the appropriate discount rate is 10 percent.
(a) Draw a detailed decision tree for this problem.
(b) Based on expected net present value, should the firm submit a proposal, and if so, how much should be spent on the initial design?