Question

Cogswell Inc. is considering launching a major R&D project that will cost $5 million or do not start the project. The probability of project success is estimated at 50%.

If successful the company need to decide to sell the rights for $25 million or invest an additional $20 million to build a facility for production. If not successful,   they just stop the project.

If they decide to build a facility for production, the net present value (NPV) of the profit stream associated with the project depends on demand as per the following table.

Demand	NPV	Probability
High	60 million	0.5
Medium	45 million	0.25
Low	25 million	0.25

Create Decision Tree

Would you recommend to launch the project or not? Explain why

What is the expected value of NPV of your recommendation?

Answer 1

Decision tree is as below

Expected Value at node 4 = 0.5*60+0.25*45+0.25*25-20 = 27.5

Expected Value at node 3 = MAX(25, 27.5) = 27.5

Therefore, optimal decision at node 3 is to build facility

Expected Value at node 2 = 0.5*27.5+0.5*0-5 = 8.75

Expected Value at node 1 = MAX(8.75, 0) = 8.75

a) Optimal decision strategy is to launch the project and if it is successful, then build facility for production.

b) Expected value of NPV of the recommendation = $ 8.75 m