Problem:
Your firm is considering investing in development of a new technology. If you invest the technology, it will require an outlay of $1.2 million. It is unclear that this investment will necessarily result in a new technology being developed. Your engineers estimate there is a 50% probability that the technology will be successful. If the new technology is successful you will have to pursue a patent on the technology. If that patent is unsuccessful, the new technology will have no value. You are being told that the probability of the patent being obtained is 60%. If the patent is successful, you may either license the technology out for $2.4million or sell the technology directly. If you sell yourself, the profitability will depend on the level of demand for the produce. Your marketing professionals tell you that there are 3 levels of demand that could prevail - high, medium and low. The profits at these 3 levels are $3million, $2million and $1million. The probabilities of these 3 levels of demand are 0.3, 0.2, 0.5 respectively. These profits include the development cost of the technology.
Q1) Need to set up as a decision tree. Using emv criterion, need to solve the tree and lay out recommendation for the company.
Q2) Outline conditions under which you may use the emv criterion. Or how can we defend emv as the appropriate decision rule?
Q3) Assume you discover your estimate of the profit from selling the new product if demand is "high" was too low. How much would the profit for "high demand" have to rise in order for you to change your decision?
Q4) Assume you learned that the probability of the patent being granted was too low. How much would that probability have to rise in order for you to change your decision?
Q5) Assume you are able to buy insurance that would pay off 1/3 of the development cost of the technology if the patent application is unsuccessful. What is the most you would be willing to pay for this insurance?