Question 1 (20 Marks)

A health clinic manger has three investment options to open new ICU units: Option A, option B, and Option C. Initial studies demonstrate different Net Present Values with different probabilities for each of the options as given in following tables.

1.1 Assuming that there is no correlation between the NPVs of the investments, calculate

and tabulate the probability distribution of the total NPVs of investing in Option A, Option B, and Option C. Please provide the following values in your calculations: Mean, the standard deviation, the total NPV associated with cumulative probability of 0.85.

1.2 Recalculate  the  mean  and  the  standard  deviation  and  tabulate  the  probability distribution  of  the  total  NPVs  assuming  perfect  negative  correlation  between  the investments. Assume that perfect negative correlation means that when the NPV for Option A are low, medium and high, the NPVs for B and C are correspondingly high, medium and low. In addition, assume that low NPV for A, but high NPVs for B and C have a 10% probability, medium NPVs for A, B and C have a 85% probability and the high NPV for A, but high NPVs for B and C have a 5% probability.

Question 2 (20 Marks)

Consider  an  investment  project  on  a  new  listening  aid  device  with  following  NPV outcomes and their conditional probabilities. We develop the device prototype, the outcome can be successful, and we can introduce the device to the market, or it may fail, and we don’t offer any new product. The 500 million dollars value of success includes the initial prototyping cost which is 30 million dollars as given as the failure value.

Success: (0.17, 500)

Failure: (0.83, -30)

2.1 The shareholders do not trust probability values and asked us to find the breakeven probability point for success. How do you calculate that? They also want you to draw a figure showing the expected NPV values as a function of probability values.

2.2 The shareholders are thinking of collaborating with another research institute and having a farmout agreement. First, suggest a farmout value that provides same EV for the NPV when the initial probability of success and failure is considered. Second, what would be the EV for the NPV in the farmout agreement if the farmout value is set to 40%?

2.3 What is the expected value of NPV if the probability of success varies within a range of (0.05-0.35)?

Question 3 (35 Marks)

A fire alarm manufacturer made a long-term agreement with a large construction company. The alarm manufacturer is looking for ways to improve its profit by investing in cost-saving measures across the whole operation to improve net cash flow. However, the manufacturer is not certain how big the savings will be and whether they will justify the investment. The manufacturer is considering carrying out an initial trial in one small part of operations to test the extent of the cost-savings measures if they are implemented. The trial might suggest that the cost-savings will be high (good) or it might suggest that the cost-savings will be low (bad). Alternatively, the factory could implement the savings measures immediately across the whole operation and not carry out the trial. Alternatively, the company could carry on the business without any cost-savings measures at all.

They have the estimates set out below (in the information below, “K” means thousand)

(a) The present value (“PV”) of the future operating costs without the trial and without any cost saving measures are $28000K.

(b) With the cost-saving measures, if the cost-savings are low (bad), the PV of the future operating costs is $26000K.

(c) With the cost saving measures, if the cost-savings are high (good), the PV of the future operating costs is 15000K.

(d) The PV of the capital and operating costs of the initial trial is $4000K.

(e) There is no initial capital costs of implementing the cost-saving measures.

(f) Without the trial and with the costs saving measures, there is 92% probability that the cost-savings will be low.

(g) The probability that the trial shows high-cost savings (good response) is 35%.

(h) If the trial of cost-saving measures are implemented and the trial suggest low saving (bad results), there is a 6% probability that the final implementation eventually leads to high-cost savings.

(i) If the trial of cost-saving measures are implemented and the trial suggest high saving (good results), there is a 85% probability that the final implementation eventually leads to low-cost savings.

Questions

3.1 Draw and solve a decision tree to help you answer the questions below.

3.2 Should the company carry out a test before implementing the new cost saving approach? Why?

3.3 What is the value of the information given by the test?

3.4 If the company carries out the test and it indicates that the cost saving measures are not very effective (low), should the company apply this cost saving approach? Why?

3.5 If the company carries out the test and it indicates high efficiency of the cost saving approach, should the company apply this approach? Why?

3.6 If the company does not carry out the test, should the company apply the cost saving approach? Why?