You and your friend have come up with an entrepreneurial idea that has great potential and you both are
trying to decide to invest in the project or not. Your initial investment for research and development (R&D) is
estimated to be $9000 total and there’s a 50-50 chance that it will be successful. If the results of the R&D
phase turn out to be successful, you will need a total of $20,000 to invest in the product’s development. If the
product goes through the development phase, uncertainty remains about the product’s demand on market and
thus uncertainty about the profit will be realized. You categorize the product demand as high, medium and
low with respective probabilities of 0.5, 0.3 and 0.2. Your best estimate of revenue projection under high
demand is $75000; at medium demand, revenue is projected at $55,000; and, at a low demand for the product,
revenue is projected at $21,000. Another option is that if the R&D phase is successful, you could sell the rights
of the product for an estimated $18,000 and not engage its development.
a) Develop the decision tree by hand and solve it according to the EMV decision criterion. State the
optimal decision according to the EMV decision criterion.
b) Create the decision tree using Treeplan.xla. Print it out and include it with your submission.
c) State the risk profile of the optimal decision according to the EMV criterion.
d) You and your friend would like to explore the sensitivity of your decision to the probability of the R&D
phase being successful or not. Create a sensitivity table (ie Data Table in Excel) showing how your
initial decision to invest $9000 might change (and its respective EMV) if the probability of a successful
R&D phase varies from 0% to 100% in steps 10%. Provide a clear statement of what the Data Table
means.
trying to decide to invest in the project or not. Your initial investment for research and development (R&D) is
estimated to be $9000 total and there’s a 50-50 chance that it will be successful. If the results of the R&D
phase turn out to be successful, you will need a total of $20,000 to invest in the product’s development. If the
product goes through the development phase, uncertainty remains about the product’s demand on market and
thus uncertainty about the profit will be realized. You categorize the product demand as high, medium and
low with respective probabilities of 0.5, 0.3 and 0.2. Your best estimate of revenue projection under high
demand is $75000; at medium demand, revenue is projected at $55,000; and, at a low demand for the product,
revenue is projected at $21,000. Another option is that if the R&D phase is successful, you could sell the rights
of the product for an estimated $18,000 and not engage its development.
a) Develop the decision tree by hand and solve it according to the EMV decision criterion. State the
optimal decision according to the EMV decision criterion.
b) Create the decision tree using Treeplan.xla. Print it out and include it with your submission.
c) State the risk profile of the optimal decision according to the EMV criterion.
d) You and your friend would like to explore the sensitivity of your decision to the probability of the R&D
phase being successful or not. Create a sensitivity table (ie Data Table in Excel) showing how your
initial decision to invest $9000 might change (and its respective EMV) if the probability of a successful
R&D phase varies from 0% to 100% in steps 10%. Provide a clear statement of what the Data Table
means.
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