Fred Wallace scratched his head. By this time tomorrow he had to have an answer for Joan Sharkey, his former boss at Plastics International (PI). The decision was difficult to make. It involved how he would spend the next 10 years of his life.

Four years ago, when Fred was working at PI, he had come up with an idea for a revolutionary new polymer. A little study—combined with intuition, hunches, and educated guesses—had convinced him that the new material would be extremely strong for its weight. Although it would undoubtedly cost more than conventional materials, Fred discovered that a variety of potential uses existed in the aerospace, automobile manufacturing, robotics, and sporting goods industries.

When he explained his idea to his supervisors at PI, they had patiently told him that they were not interested in pursuing risky new projects. His appeared to be even riskier than most because, at the time, many of the details had not been fully worked out. Furthermore, they pointed out that efficient production would require the development of a new manufacturing process. Sure, if that process proved successful, the new polymer could be a big hit. But without that process the company simply could not provide the resources Fred would need to develop his idea into a marketable product.

Fred did not give up. He began to work at home on his idea, consuming most of his evenings and weekends. His intuition and guesses had proven correct, and after some time he had worked out a small-scale manufacturing process. With this process, he had been able to turn out small batches of his miracle polymer, which he dubbed Strenlar. At this point he quietly began to assemble some capital. He invested $500,000 of his own, managed to borrow another $500,000, and quit his job at PI to devote his time to Strenlar.

That was 15 months ago. In the intervening time he had made substantial progress. The product was refined, and several customers eagerly awaited the first production run. A few problems remained to be solved in the manufacturing process, but Fred was 80% sure that these bugs could be worked out satisfactorily. He was eager to start making profits himself; his capital was running dangerously low. When he became anxious, he tried to soothe his fears by recalling his estimate of the project’s potential. His best guess was that sales would be approximately $35 million over 10 years, and that he would net some $8 million after costs.

Two weeks ago, Joan Sharkey at PI had surprised him with a telephone call and had offered to take Fred to lunch. With some apprehension, Fred accepted the offer. He had always regretted having to leave PI, and was eager to hear how his friends were doing. After some pleasantries, Joan came to the point.

“Fred, we’re all impressed with your ability to develop Strenlar on your own. I guess we made a mistake in turning down your offer to develop it at PI. But we’re interested in helping you out now, and we can certainly make it worth your while. If you will grant PI exclusive rights to Strenlar, we’ll hire you back at, say $80,000 a year, and we’ll give you a 2.5% royalty on Strenlar sales. What do you say?”

Fred didn’t know whether to laugh or become angry. “Joan, my immediate reaction is to throw my glass of water in your face! I went out on a limb to develop the product, and now you want to capitalize on my work. There’s no way I’m going to sell out to PI at this point!”

The meal proceeded, with Joan sweetening the offer gradually, and Fred obstinately refusing. After he got back to his office, Fred felt confused. It would be nice to work at PI again, he thought. At least the future would be secure. But there would never be the potential for the high income that was possible with Strenlar. Of course, he thought grimly, there was still the chance that the Strenlar project could fail altogether.

At the end of the week, Joan called him again. PI was willing to go either of two ways. The company could hire him for $100,000 plus a 6% royalty on Strenlar gross sales. Alternatively, PI could pay him a lump sum of $500,000 now plus options to purchase up to 70,000 shares of PI stock at the current price of $40 any time within the next 3 years. No matter which offer Fred accepted, PI would pay off Fred’s creditors and take over the project immediately. After completing development of the manufacturing process, PI would have exclusive rights to Strenlar. Furthermore, it turned out that PI was deadly serious about this game. If Fred refused both of these offers, PI would file a lawsuit claiming rights to Strenlar on the grounds that Fred had improperly used PI’s resources in the development of the product.

Consultation with his attorney just made him feel worse. After reviewing Fred’s old contract with PI, the attorney told him that there was a 60% chance that he would win the case. If he won the case, PI would have to pay his court costs. If he lost, his legal fees would amount to about $60,000.

Fred’s accountant helped him estimate the value of the stock options. First, the exercise date seemed to pose no problem; unless the remaining bugs could not be worked out, Strenlar should be on the market within 18 months. If PI were to acquire the Strenlar project and the project succeeded, PI’s stock would go up to approximately $52. On the other hand, if the project failed, the stock price probably would fall slightly to $39.

As Fred thought about all of the problems he faced, he was quite disturbed. On one hand, he yearned for the comradery he had enjoyed at PI 4 years ago. He also realized that he might not be cut out to be an entrepreneur. He reacted unpleasantly to the risk he currently faced. His physician had warned him that he may be developing hypertension and had tried to persuade him to relax more. Fred knew that his health was important to him, but he had to believe that he would be able to weather the tension of getting Strenlar into the market. He could always relax later, right? He sighed as he picked up a pencil and pad of paper to see if he could figure out what he should tell Joan Sharkey.

Do a complete analysis of Fred’s decision. Your analysis should include at least structuring the problem with an influence diagram, drawing and solving a decision tree, creating risk profiles, and checking for stochastic dominance. What do you think Fred should do? Why? 

Answer rating: 100% (QA)

To solve the problem we need to consider some assumptions These are as follows a The sales are distr... View the full answer