QUESTION 1 [25 Marks]

EVALUATING R&D PROJECTS AT WESTCOM SYSTEMS PRODUCTS COMPANY

West-Com Systems Products Company develops computer systems and software products for commercial sale. Each year it considers and evaluates a number of different R&D projects to undertake. It develops a road map for each project, in the form of a standardized decision tree that identifies the different decision points in the R&D process from the initial decision to invest in a project's development through the actual commercialization of the final product.

The first decision point in the R&D process is whether to fund a proposed project for 1 year. If the decision is no, then there is no resulting cost; if the decision is yes, then the project proceeds at an incremental cost to the company. The company establishes specific short-term, early technical milestones for its projects after 1 year. If the early milestones are achieved, the project proceeds to the next phase of project development; if the milestones are not achieved, the project is abandoned. In its planning process the company develops probability estimates of achieving and not achieving the early milestones. If the early milestones are achieved, the project is funded for further development during an extended time frame specific to a project. At the end of this time frame, a project is evaluated according to a second set of (later) technical milestones. Again, the company attaches probability estimates for achieving and not achieving these later milestones. If the later milestones are not achieved, the project is abandoned.

If the later milestones are achieved, technical uncertainties and problems have been overcome, and the company next assesses the project's ability to meet its strategic business objectives. At this stage, the company wants to know if the eventual product coincides with the company's competencies and whether there appears to be an eventual, clear market for the product. It invests in a product "prelaunch" to ascertain the answers to these questions.

The outcomes of the prelaunch are that either there is a strategic fit or there is not, and the company assigns probability estimates to each of these two possible outcomes. If there is not a strategic fit at this point, the project is abandoned and the company loses its investment in the prelaunch process. If it is determined that there is a strategic fit, then three possible decisions result: (1) The company can invest in the product's launch, and a successful or unsuccessful outcome will result, each with an estimated probability of occurrence; (2) the company can delay the product's launch and at a later date decide whether to launch or abandon; and (3) if it launches later, the outcomes are success or failure, each with an estimated probability of occurrence. Also, if the product launch is delayed, there is always a likelihood that the technology will become obsolete or dated in the near future, which tends to reduce the expected return.

The following table provides the various costs, event probabilities, and investment outcomes for five projects the company is considering:

Project
Decision Outcomes/Event	1	2	3	4	5
Fund 1 year	$200,000	$350,000	$170,000	$230,000	$400,000
P(Early milestones, Yes)	.70	.67	.82	.60	.75
P(Early milestones, No)	.30	.33	.18	.40	.25
Long-term Funding	$650,000	780,000	450,000	300,000	450,000
P(Late milestones, Yes)	.60	.56	.65	.70	.72
P(Late milestones, No)	.40	.44	.35	.30	.28
Prelaunch Funding	$300,000	450,000	400,000	500,000	270,000
P(Strategic fit, Yes)	.80	.75	.83	.67	.65
P(Strategic fit, No)	.20	.25	.17	.33	.35
Invest, Success	$7,300,000	8,000,000	4,500,000	5,200,000	3,800,000
P(Invest, Success)	.60	.65	.70	.75	.80
Invest, Failure	$2,000,000	3,500,000	1,500,000	2,100,000	900,000
P(Invest, Failure)	.40	.35	.30	.25	.20
Delay, Success	$4,500,000	6,000,000	3,300,000	2,500,000	2,700,000
P(Delay, Success)	.80	.70	.65	.80	.85
Delay, Failure	$1,300,000	4,000,000	800,000	1,100,000	900,000
P(Delay, Failure)	.20	.30	.35	.20	.15

Determine the expected value for each project and then rank the projects accordingly for the company to consider.

This case was adapted from R. K. Perdue, W. J. McAllister, P. V. King, and B. G. Berkey, "Valuation of R and D projects Using Options Pricing and Decision Analysis Models," Interfaces 29, no. 6 (November-December 1999): 5774.