You are responsible for the R&D Department in your company. You must decide weather to spend $2
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- You are responsible for the R&D Department in your company. You must decide weather to spend $2 million now (beginning of Year 1) to continue with a particular research project. The success of the project (as measured by obtaining a patent) is not assured. At this point, the chance of succeeding is judged to be 70%.
If the project is successful, you will be able to license the patent in one year (Year 2) for a total cash inflow of $25 million which is to be distributed to your department as $5 million per year starting in Year 3 for 5 years.
On the other hand, you also have the option to commercialize the patent (i.e., invest in making then selling the product based on the patent). Here, you will need to invest $5 million in each of Years 3 and 4. If you do that, you profit will be $11 million, $6.6 million or $3 million each year in the next five years (Year 5-9) if the demand is high, medium or low. The probability for the high, medium and low level of demand for your product is estimated to be 25%, 55% and 20% respectively.
- Draw out the structure of the decision tree that can help you make the above decisions (8 points)
- Calculate and fill out all the numbers to complete the decision tree, please show the calculations of the numbers when needed. You may use a discount rate of 8% to roll back future cash flow into the present (8 points)
- Calculate EMV and indicate your optimal decision (4 points)
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