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Homework #1: Decision Making AEM 424 1. Software Marketing You have developed a popular piece of business software that runs on the Windows platform. You recognize that the Linux platform is growing in popularity and have developed a version of the program to run on Linux. That development cost you \$2 million, money that you have already spent. To sell the Linux version, however, you also must do a marketing campaign, which will cost \$1 million. You aren't sure, however, whether Linux will be successful as a platform for business users. If it is, you will sell a lot of copies of your program for Linux (for a profit of \$6m after production and distribution expenses, not counting development or marketing). If not, you will sell very few copies (for a profit of \$500,000 after production and distribution expenses, not counting development or marketing). You estimate the probability of Linux succeeding at 0.7. a. What should the firm do? Draw a decision tree. b. A consultant says that she can do a study of the market and tell you with certainty whether or not Linux will succeed as a business platform. She can do this study before you make your investment in marketing the software for Linux. How much is it worth to you to know whether Linux will succeed before you have to make the marketing decision? a. See decision tree below. You have already developed the software, so that \$2 million is a sunk cost (assuming you can’t see the software). Forget about it. The expected value of marketing the software is \$3,350,000, which is greater than the expected value of not marketing, which is \$0. So, not knowing whether or not Linux will succeed, the best you can do is to get \$3,350,000 on average. Now suppose you know whether or not Linux will succeed. If Linux does succeed, a situation you will face with probability 0.7, you will chose to market with a profit of \$5,000,000. If Linux does not succeed, a situation you will face with probability 0.3, you will chose not to market with a payout of \$0. So, on average, you will get 0.7(\$5,000,000)+0.3(\$0)=3,5000,000. The value of knowing the information is thus the difference between the best you can do knowing and the best you can do not knowing: \$3,500,000-\$3,350,000=\$150,000.

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2. VC Decision Tree You are raising \$10 million for a new venture. You know that you can borrow the money from your rich uncle, but then you would have to put up with him looking over your shoulder all the time. It is worth \$50,000 to you to get the financing from a venture
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