# Question

A professor in the Computer Science department at United States Institute of Technology has just patented a new search engine technology and would like to sell it to you, an interested venture capitalist. The patent has a 17-year life. The technology will take a year to implement (there are no cash flows in the first year) and has an upfront cost of $100 million. You believe this technology will be able to capture 1% of the Internet search market, and currently this market generates profits of $1 billion per year. Over the next five years, the risk-neutral probability that profits will grow at 10% per year is 20% and the risk-neutral probability that profits will grow at 5% per year is 80%.

This growth rate will become clear one year from now (after the first year of growth). After five years, profits are expected to decline 2% annually. No profits are expected after the patent runs out. Assume that all risk-free interest rates are constant (regardless of the term) at 10% per year.

a. Calculate the NPV of undertaking the investment today.

b. Calculate the NPV of waiting a year to make the investment decision.

c. What is your optimal investment strategy?

This growth rate will become clear one year from now (after the first year of growth). After five years, profits are expected to decline 2% annually. No profits are expected after the patent runs out. Assume that all risk-free interest rates are constant (regardless of the term) at 10% per year.

a. Calculate the NPV of undertaking the investment today.

b. Calculate the NPV of waiting a year to make the investment decision.

c. What is your optimal investment strategy?

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