Hemmingway, Inc., is considering a $4 million research and development (R&D) pro

Question

Hemmingway, Inc., is considering a $4 million research and development (R&D) project. Profit projections appear promising, but Hemmingway's president is concerned because the probability that the R&D project will be successful is only 0.50. Furthermore, the president knows that even if the project is successful, it will require that the company build a new production facility at a cost of $15 million in order to manufacture the product. If the facility is built, uncertainty remains about the demand and thus uncertainty about the profit that will be realized. Another option is that if the R&D project is successful, the company could sell the rights to the product for an estimated $25 million. Under this option, the company would not build the $15 million production facility.

The decision tree is shown in Figure 13.18. The profit projection for each outcome is shown at the end of the branches. For example, the revenue projection for the high demand outcome is $62 million. However, the cost of the R&D project ($6 million) and the cost of the production facility ($16 million) show the profit of this outcome to be $62 ? $6 ? $16 = $40 million. Branch probabilities are also shown for the chance events.

What is the expected value of your strategy? If required, round your answer to 2 decimal places.

Expected value = $  M

What must the selling price be for the company to consider selling the rights to the product? If required, round your answers to 2 decimal places.

Payoff for sell rights would have to be $  M or more. In order to recover the $4M R&D cost, the selling price would have to be $  M or more.

Develop a risk profile for the optimal strategy. If required, round your answers to two decimal places.

Possible Profit Associated Probability $36M $16M $6M -$4M
FIGURE 13.1 18 DECISION TREE FO R HEMMINGWAY, INC Profit (S millions) 40 0.5 Medium Demand 0.3 Low Demand 0.2 Building Facility (S16 million) 23 13 Successful 0.4 Start R&D; Project (S6million) 19 Not Successful -6 0.6 Do Not Start the R&D; Project 0

Explanation / Answer

Solution

Back-up Theory

EMV(Expected Monetary Value) of a strategy (decision alternative)

= ?(pay-off)(probability of pay-off), summed over all possible pay-offs of the strategy.

Part (a)

At node (4), EMV of ‘Building Facility’ = (40 x 0.5) + (23 x 0.3) + (13 x 0.2) = 29.5

At node (3), EMV of ‘Building Facility’ = 29.5 > EMV of ‘Selling Rights) = 19.

Hence, strategy is ‘Building Facility’.

At node (2), EMV of ‘Start R & D Project’ = (29.5 x 0.4) + (- 6 x 0.6) = 8.2

At node (1), EMV of ‘Start R & D Project’ = 8.2 > EMV of ‘Do Not Start R & D Project’ = 0.

Hence, strategy is ‘Start R & D Project’.

So, the strategy is: ‘Start R & D Project’, and if it is successful ‘Build Facility’     

ANSWER: option 1/

Part (b)

Since the strategy is: ‘Start R & D Project’, and if it is successful ‘Build Facility’, expected value of the strategy is the EMV of R & D Project being successful, which, as worked out in Part (a) is

$8.2 million ANSWER

Part (c)

At node (3), EMV of ‘Building Facility’ = 29.5. Hence, ‘selling rights’ to be a better strategy, the price must be greater than $29.5 million ANSWER

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