Question

In Module 1, we introduced the concept of discount rates – the idea that value in the future is not worth as much as value today. We’re going to ignore those right now for simplicity, and assume that the discount rate is zero. Ignoring discount rates means we can just multiply the probabilities and payoffs to determine the expected value of the investment:

($1,000,000 * 20%) + ($0 * 80%) = $200,000

This is the present value of the uncertain future cash flow.

$200,000 − $100,000 = $100,000

This is the net present value of the uncertain future cash flow (in other words, the positive future cash flow value, minus the cost to build the company).

As you can see, the project has a net present value of $100,000 – the expected payoff is $200,000, which is only twice the $100,000 investment required to start it. Your idea is profitable though not terribly exciting given the high risk.

Let’s say you identify an experiment that would cost $25,000 to run. You’d like to test a beta version of the app in Washington D.C. that matches dogs with local dog walkers and provides an easy way for owners to communicate with the dog walkers.

If the experiment works, you could discover that the probability of failure decreases from 80% to 50%, raising the probability of success from 20% to 50%. How much would the project be worth under those conditions? Use the same equation above and change the probabilities, assuming the discount rate is still 0%.

How much would the project be worth under those conditions? How did you come up with this answer?

Pick from 4 :

100,000$

400,000$

500,000$

1,000,000$

Answer 1

The Payoff if it is successful = $1,000,000
The payoff if its a failure = $0
Cost of Project = $100,000

New Probability of success = 50%
New Probability of Failure = 50%

Expected Value of investment = (Probability of success * Payoff if it is successful) + (Probability of failure * Payoff if it is a failure)
= (0.5 * 1000000) + (0.5 * 0)
= 500,000

Discount Rate = 0%

Present Value of uncertain cash flow = Expected value - cost of investment
= 500,000 - 100,000
Present Value of uncertain cash flow = 400,000