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ch8 - Chapter 8 Risk Analysis Real Options and Capital...

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Chapter 8: Risk Analysis, Real Options, and Capital Budgeting 8.1 Calculate the NPV of the expected payoff for the option of going directly to market. NPV(Go Directly) = C Success (Prob. of Success) + C Failure (Prob. of Failure) = \$20,000,000 (0.50) + \$5,000,000 (0.50) = \$12,500,000 The expected payoff of going directly to market is \$12,500,000. The test marketing requires a \$2 million cash outlay. Choosing the test marketing option will also delay the launch of the product by one year. Thus, the expected payoff is delayed by one year and must be discounted back to year 0. NPV(Test Market) = -C 0 + [C Success (Prob. of Success)] / (1+r) T + [C Failure (Prob. of Failure)] / (1+r) T = -\$2,000,000 + [\$20,000,000 (0.75)] / (1.15) + [\$5,000,000 (0.25)] / (1.15) = \$12,130,434.78 The expected payoff of test marketing the product is \$12,130,434.78. Sony should go directly to market with the product since that option has the highest expected payoff. 8.2 Calculate the NPV of each option. The manager should pursue the option with the highest NPV. NPV(Go Directly) = C Success (Prob. of Success) = \$1,200,000 (0.50) = \$600,000 The NPV of going directly to market is \$600,000. NPV(Focus Group) = C 0 + C Success (Prob. of Success) = -\$120,000 + \$1,200,000 (0.70) = \$720,000 The NPV when conducting a focus group is \$720,000. NPV(Consulting Firm) = C 0 + C Success (Prob. of Success) = -\$400,000 + \$1,200,000 (0.90) = \$680,000 The NPV when hiring a consulting firm is \$680,000. The firm should conduct a focus group since that option has the highest NPV. B-162

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