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Ed Draycutt is the engineering manager of Airway Technologies, a firm that makes computer systems for air traffic control installations at airports.  He has proposed a new device the success of which depends on two separate events.  First the Federal Aviation Administration (FAA) must adopt a recent proposal for a new procedural approach to handling in flight calls from planes experiencing emergencies.

Everyone thinks the probability of the FAA accepting the new method is at least 98%, but it will take a year to happen.  If the new approach is adopted, radio makers will have to respond within another year with one of two possible changes in their technology.  These can simply be called A and B.  The A response is far more likely, also having a probability of about 98%.  Ed’s device works with the A system and is a stroke of engineering genius.  If the A system becomes the industry standard and Airway has Ed’s product, it will make a fortune before anyone else can market a similar device.

On the other hand if the A system isn’t adopted, Airway will lose whatever it’s put into the new device’s development.

Developing Ed’s device will cost about \$20 million, which is a very substantial investment for a small company like Airway.  In fact, a loss of \$20 million would put the firm in danger of failing.

Ed just presented his idea to the executive committee as a capital budgeting project with a \$20 million investment and a huge NPV and IRR reflecting the adoption of the A system.

Everyone on the committee is very excited.  You’re the CFO and are a lot less excited.  You asked Ed how he reflected the admittedly remote possibility that the A system would never be put in place.  Ed, obviously proud of his business sophistication, said he’d taken care of that with a statistical calculation.

He said adoption of the A system required the occurrence of two events each of which has a 98% probability.  The probability of both happening is (.98x.98=.96) 96%.  He therefore reduced all of his cash inflow estimates by 4%.  He maintains this correctly accounts for risk in the project.

In this assignment you will:

Evaluate Ed’s analysis. Does Ed have the right expected NPV? What’s wrong with his analysis?

1. Suggest an approach that will give a more insightful result.
2. Discuss why the firm might consider passing on the proposal in spite of the tremendous NPV and IRR Ed has calculated?
3. Evaluative if Ed’s case be might be helped by a real option. If so, what kind? How would it help?
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Step 1

Evaluate Ed’s analysis. Does Ed have the right expected NPV? What’s wrong with his analysis?

Ed has mathematically the right expected NPV, because the exepcted NPv is derived from the exected cash flows which are probability weighted. hence, mathematiclly there is no problem in his calculation.

However, his expected NPV calculation fails to highlight the fact that the firm faces the risk of huge loss of \$ 20 mn in case of unfavorable outcome. His analysis doesn't signify that there always exists a finite probability however small it may be, that there will be a failure and the firm will loe \$ 20 mn which is quite significant for a firm of this size.

Step 2

Suggest an approach that will give a more insightful result.

• Adopt a decision tree approach: mathematically we will end up with the same NPV, but management will be fully aware of the risk and quantum of loss. Management can then take an informed decision.
• Increase the discount rate used for discounting the cash flow to reflect the high loss even though the probability of loss is small. A higher discount rate may add a new perspective of looking at the proj...

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