Question

Final Assignment

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 have 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?
Step 1

Evaluation of Ed’s analysis:

Net present value is the one of the best techniques of capital budget assessment. It is the difference between the present value of cash outflows and present value of cash inflows from a project. Normally if a cash inflow exceeds cash outflow then the outcome is accepted that is when a NPV is positive a project or the outcome is accepted. In the given case, Ed’s shows a positive NPV but he did not disclose the 4% probability of the projects failure separately. This 4% probability failure will affect the company rigorously. Ed’s net present value is totally based on the 4% probability of failure and 96% probability of success.

Thus, this will ultimately provide Ed a high cash inflows, high NPV, and high IRR and providing these high values of IRR and NPV might mislead the company.

Step 2

Suggestions:

Though, airway technologies is a small company a \$20 million is a huge investment for it, even if it has a 4% failure. So under this situation Ed needs to explain the management the way he arrived the expected IRR (Internal rate of return) and NPV (Net present value). He needs to explain the consequences and risk associated with the 4% probability of failure to the management.

Step 3

Discussion on the reason why the company passes on the proposal though it has a tremendous IRR and NPV:

There are various reason for the management to pass on the proposal determined by Ed are as follows:

• The risk and consequence associated with 4% probability of failure
• ...

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