Problem
Intel recently announced the successful design of a computer chip that transmits and receives long-range, high-speed wireless Internet signals. This chip can be incorporated into modems, enabling them to pick up so-called WiMax transmissions, which can carry data traffic over more than 20 miles. LongRange (LR) is a high-tech company that specializes in state-of-the-art wireless connectivity. LR is considering buying from Intel a two-year license of the WiMax production process in order to manufacture WiMax modems. A cash flow analysis of the project while under license suggests that at the end of each year under license the demand for this product will generate an expected cash inflow of $150 million per year. After the license expires, LR will no longer be able to realize any profits. Intel is currently offering the license for a one-time cost of $25 million. After purchasing the license, LR must still make significant up-front capital investment before the company can sell Wi-Max modems. If made today, the required up-front investment is $390 million. The license will expire two years after it is purchased, regardless of when this initial investment is made. The first positive cash flow from the project will arrive one year after the up-front initial capital investment.
The proper discount rate for all uncertain cash flows is 10%.
I. Should LR buy the license and make the capital investment today? Explain.
II. As with all cutting-edge technologies, the up-front capital outlay is expected to decrease over time. LR's economist estimates that the up-front investment cost is equally likely to either go up by 25% or go down by 70% each year from the previous year's cost for at least the next three years. What is the maximum price that LR should be willing to pay for the license today?
III. Negotiations with Intel over the license fee have stalled. Though Intel is not willing to lower the fee, for the same fee today, they will increase the duration of the license agreement by one year. The agreement will still begin today. In this case, what is LR willing to pay for the licensing fee today? Explain.