Decision Tree: EDC, Inc.\
East Digital Centrum, Incorporated (EDC) is considering the development and launch of a new wireless data network product that will comply with a new high-bandwidth standard. The launch is scheduled for two years from now, which is also about the time when EDC predicts its competitors will be ready to launch competing products.
Product development costs are estimated at $5 million. (All the numbers in this problem are given in present value, so no need to discount.) The development (i.e., the design and prototype) can be completed within one year from now.
However, EDC is unsure of whether its engineering department will come up with a superior design, i.e., a “winning product” that is appealing to consumers and that technically outshines the competition. One year from now, all companies that plan to enter this market will have to demonstrate their products at the industry’s trade fairs. At that time, judging by the reaction of industry analysts and by comparing its product to those shown by the competition, EDC will be able to assess whether it has a winning product. EDC estimates the probability that its product will indeed be a superior design at 30%.
There is also a significant uncertainty about the size of the market for high-bandwidth wireless data networks. For simplicity, EDC is modeling this uncertainty as two scenarios, “large market” and “small market,” with probabilities 60% and 40%, respectively. This uncertainty will only be resolved after the product is launched two year from now. The estimated present value of the profit contribution from the product over its life-cycle in each of the four scenarios is given in the table below, in million USD
Large market (P=0.6) Small market (P=0.4)
Superior design (P=0.3) 100 30
Non-superior design (P=0.7) 10 -10
To calculate the net profit in each scenario, the cost of development and the cost of construction of the production facility must be subtracted from the amounts given in the table. Current planning requires that the construction of the production facility start immediately, even though the product is still in development. The construction of the facility represents an expenditure of $25 million within the next year.
a) Build a tree to evaluate the project (i.e., the development and launch of the new product). Find the expected value for the project.
Expected Value: _____________________ Find the risk profile for the project; that is, list all possible values of the project’s net profits and their corresponding probabilities. In particular, what is the probability of incurring no loss.
Pr(net profit >= 0): ______________________ (Show how you get this number) Would you recommend that EDC pursue the project as described above? Why or why not?
b) There is strong disagreement in EDC’s engineering department concerning the 30% probability of having a winning product. Harris Walters, EDC’s VP of Engineering, claims that it could be as high as 70%.
How does the value of the project and optimal decision obtained in Part a) vary as Pr(winning product) ranges from 0% to 100% (in an increment of 5%)? Use Excel’s Data Table function to answer this question.
Pr(winning product) needs to be higher than _________________ in order for EDC to pursue the project.
C). Charlie Lin, a summer intern at EDC, suggests that it may be worthwhile to delay the decision to construct the facility for one year, when the quality of the product will be known. Suppose that the facility can be ready at the same cost of $25 million if its construction is delayed for one year. (For simplicity, ignore the effects of discounting this number for an additional year and assume that the previous probability and profit assessments still hold.) Revise the tree you drew in Part a) to include the “delay construction decision” alternative. What is its expected value? (Hint: this is not value of information, but you may want to recall how we draw the tree to calculate value of information.)
Expected value of the “delay construction decision” alternative: ___________________
In reality, there is going to be all sorts of costs associated with delaying the facility construction. What is the most EDC should be willing to pay – in terms of these additional costs – in order to secure with the contractor the option to delay building the production facility for one year?
Maximum EDC should pay in additional costs to secure the “delay construction decision” alternative: ___________________