Question

Describe the benefits and costs of delaying an investment opportunity.

Your engineers are developing a new product to launch next year that will require both software and hardware innovations. The software team requests a budget of $5 million and forecasts an 80% chance of success. The hardware team requests a $10 million budget and forecasts a 50% chance of success. Both teams will need 6 months to work on the product, and the risk-free interest rate is 4% APR with semiannual compounding.

a.     Which team should work on the project first?

b.     Suppose that before anyone has worked on the project, the hardware team comes back and revises their proposal, changing the estimated chance of success to 75% based on new information. Will this affect your decision in (a)?

Answer 1

Answer to a)

Given 4 % APR (Which is annual Percentage Rate) with semi annual compounding.

Therefore 6 months Interest Rate - 4%/2 = 2%

Now, Analysis of Development by Software Team

Initial Outflow - $5 million

Expected Inflow - 80% Chance of Success

Which implies - 80%* $5 million

= $ 4 Million

Present Value of Future Cash inflow = $ 4 Million / 1.02 = $ 3.92 Million

Now NPV = - $ 1.08 Million (Outflow -Inflow)

Now, Analysis of Development by Hardware Team

Initial Outflow - $10 million

Expected Inflow - 50% Chance of Success

Which implies - 50%* $10 million

= $ 5 Million

Present Value of Future Cash inflow = $ 5 Million / 1.02 = $ 4.90 Million

Now NPV = - $ 5.1 Million (Outflow -Inflow)

Therefore we see that the chances of loss (in monetary Terms as computed above) in the development by the software team is less as compared to the hardware team. Therefore software team should work first on the project.

Answer to b)

Now the revised Expected Cash inflow of Hardware team - 75% of Success

=75% of $ 10 Million

$ 7.5 Million

Now Present Value of the inflow = $ 7.5 Million/ 1.02 = $ 7.35 Million

NPV = - $ 2.64 Million

On the basis of new information we see that chance of loss of the development by the hardware team is less as compared to the software team on the basis of new information.

Therefore Harware team to be first allowed to do the development.