Ch008 - 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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8.3 Recommend the strategy that has the highest NPV. NPV(Lower Prices) = C Success (Prob. of Success) + C Failure (Prob. of Failure) = -$1,300,000 (0.55) - $1,850,000 (0.45) = -$1,547,500 NPV(Lobbyist) = C 0 + C Success (Prob. of Success) + C Failure (Prob. of Failure) = -$800,000 - $0 (0.75) - $2,000,000 (0.25) = -$1,300,000 The CFO should hire the lobbyist since that option has the highest NPV. 8.4 Since the NPV of Research is greater than that of no research, based on expected outcomes, B&B should go directly to market. Note: Research = –1 million investment + 0.7 * (26.087) if successful + 0.3 * (2.6087) if unsuccessful No Research = 0.55 * (30) if successful + 0.45 * (3) if unsuccessful B-163 Start Research No Research $17.85 million at t = 0 Success Failure Success Failure $30 million at t = 1 (26.087 million at t = 0) $3 million at t = 1 (2.6087 million at t = 0) $30 million at t = 0 $3 million at t = 0
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8.5 Carl should have taken the $5,000. Expected return for 1% of movie profits is $3,000. Since only good scripts are made into movies and only a good movie would make a profit: (10% x 30% x $10 mil x 1%) Movie studio decision tree: Script is bad Don’t make movie 90% No profit Read script Script is good Make Movie Movie is good Movie is bad Big Audience Small Audience 10% No profit 30% 70% Profit = $10 million No Profit -164
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8.6 Apply the accounting profit break-even point (BEP) formula and solve for the sales price, x , that allows the firm to break even when producing 20,000 calculators. In order for the firm to break even, the revenues from the calculator sales (number of calculators sold × sales price per unit) must equal the total annual cost of producing the calculators. Remember to include taxes in the analysis. Variable costs = $15 per calculator Fixed costs = $900,000 per year Depreciation = (Initial Investment / Economic Life) = ($600,000 / 5) = $120,000 per year Divide the after-tax sum of the depreciation expense and the fixed costs by the calculator’s after-tax contribution margin (selling price, x , minus variable cost).
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Ch008 - Chapter 8: Risk Analysis, Real Options, and Capital...

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