The figure shows a decision tree with cash flows and probabilities fully specifi
ID: 3056096 • Letter: T
Question
The figure shows a decision tree with cash flows and probabilities fully specified. This is a research-and-development decision. The decision maker is a company that must decide whether to spend $2 million to continue with a particular research project. The success of the project (as measured by obtain- ing a patent) is not assured, and at this point the decision maker judges only a 70% chance of getting the patent. If the patent is awarded, the company can either license the patent for an estimated $25 million or invest an addi- tional $10 million to create a production and marketing system to sell the product directly. If the company chooses the latter, it faces uncertainty of demand and associated profit from sales.
Draw the respective infeluence diagram?
License Technolog.y $23M Paten Awarded p=0.7 Continue Development -$2M Demand High p= 0.25 S55M_ $43M and Marketing to Sell Product Directly -$10M Demand Medium p= 0.55 $33M-$21M No Patent- -$2M p = 0.3 p= 0.20 $15M-$3M Stop Developmen $0Explanation / Answer
Sol: In the first node (far right).
In case the profits are 55M for high demand,33M for medium demand and 15M for low demand.
The EMV on the 1st node is 55M*0.25+33M*0.55+15M*0.20 = 34.9M
Now the cost of developing production and marketing to sell is 10m therefore the return would be 34.9M-10M = 24.9M
If the company gets 25M from license Technology than the company do that. If it gets 23M then it should invest in marketing.
In case the company gets 25M, then the EMV at node 2, continue development is
0.70*25M+0.30*(-2M)
=16.9M
Therfore the company should continue development and patent its technology.
Let us take the case where high demand is 43M, Medium Demand is 21M and Low Demand is 3M
the EMV at node 1 is 43M*0.25+21M*0.55+3M*0.20 = 22.9M
Now the cost of developing production and marketing to sell is 10m, therefore the return would be 22.9M-10M = 12.9M
Therefore the company should invest in marketing as 25M and 23M are greater than 12.9M
In case the company gets 23M, then the EMV at node 2, continue development is
0.70*23M+0.30*(-2M)
=15.5M
Therfore the company should continue development and patent its technology.
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