As she was driving home Friday evening, Yiduo Chen, Vice President of Sales & Marketing at Lexing-ton Laser Corporation (LLC), kept thinking about the interesting opportunity she stumbled upon during last week's west-coast business development trip. It seems that Aspen Networks, an emerging company in the network business, requires a custom laser transmitter for one of their new transmission systems.

Because Aspen's strength is in communications systems and not in optoelectronic components, they indicated that they are interested in forging a strategic supply arrangement with LLC (or perhaps some other opto-electronic component manufacturer) for the supply of custom laser transmitters. Aspen is confident that they can carve out a leadership position in the market with their new system which could translate into $10 million in laser transmitter orders for LLC over three years. Yiduo was definitely excited about this potential opportunity for LLC.

After reviewing the technical specifications for the custom part with Peter Williams (VP of Engineering), it appeared that with minimal engineering investment LLC could adapt one of their existing designs to obtain the requisite functionality. Yiduo then started working with the manufacturing folks: Julie Weller (VP of Manufacturing) and Steve Lo (Manufacturing Engineering Manager). Julie and Steve felt that although there was sufficient excess capacity at LLC to produce the required laser chips, the rest of the manufacturing process for the custom lasers would require establishing a small dedicated manufacturing line at a cost of $800,000. It would take four months to build this facility - just three months before LLC would expect the first orders from Aspen.

Yiduo then tried to look more carefully at the numbers. The Aspen management team was optimistic that they could capture enough business to provide LLC with orders for 10,000 lasers over three years. Indeed, at a price of $1,000 per laser (giving the $10 million revenue mentioned earlier) and 20% after- tax profit margins, this opportunity seemed profitable. However, as Yiduo studied the network market a bit closer, she learned that while Aspen had some leading edge technologies and a novel approach, Aspen also had two established competitors, and the optimistic scenario above may not materialize.

Yiduo also thought that given the rapid pace of technological innovation and commercialization in the communications industry, this custom laser would most probably have a relatively brief lifecycle of three years, and that much of the dedicated manufacturing facility would not have an alternate use beyond the third year. With input from Aspen and their customers, Yiduo estimated the best-case and worst- case revenues (corresponding to the range of Aspen's acceptance in the market) and post-tax profit projections as follows:

Best-case: Year 1 revenue $2 million, Year 2 revenue $ 5 million, Year 3 revenue $ 3 million. This gave a total revenue of $10 million over three years yielding after-tax profits (excluding the cost of setting up the dedicated manufacturing line) of $2 million.

Worst-case: Year 1 revenue $0.5 million, Year 2 revenue $ 1.25 million, Year 3 revenue $ 0.75 million. This gave a total revenue of $2.5 million over three years yielding after-tax profits (excluding the cost of a dedicated manufacturing line) of $ 0.5 million.

The probability of "Best-case" is subjectively estimated to be 70%.

At a meeting with the Aspen team, Yiduo explained her company's reluctance to invest in a custom manufacturing facility with an uncertain future. Hank Philips (purchasing manager of Aspen) then explained that Aspen has also been talking with another laser manufacturer to explore contract manufacturing of custom lasers. Although LLC was Aspen's first choice, the other manufacturer had already committed the resources for a dedicated line, and Aspen had even placed preliminary orders. Yiduo then brought up the possibility for LLC to wait six months before committing to the dedicated line, to see how Aspen's new system fares in the marketplace. Hank explained that while they would be willing to work with LLC for the following two years, the laser orders they would place with LLC for years two and three would then be smaller by approximately 30%. That is, the best case under the strategy of waiting six months before committing: Year 1 revenue $ 0, Year 2 revenue $3.5 million, Year 3 revenue $ 2.1 million.

Worst-case under the strategy of waiting six months before committing: Year 1 revenue $ 0, Year 2 revenue $0.875 million, Year 3 revenue $ 0.525 million.

While the revenue opportunity was lower in the more conservative approach of waiting six months before building the line, it would allow LLC to know exactly whether Aspen would be successful ("best-case") or not ("worst-case") in the marketplace. In the event Aspen was not successful, LLC would be spared the investment in a manufacturing facility that would not pay for itself.

As Yiduo drove home, she mulled over the options. Build the facility or not? Hold off for six months to see whether Aspen is successful?"

 

Can I please have help with the following:

a) What is the expected payoff (including the cost to set up the facility) if LLC decides to go ahead with the alliance with Aspen now? Assume a discount rate of 0% throughout this question. 

b) What is the expected payoff if the LLC decides to wait 6 months?

c) The chance of Aspen's success success = 70% was a subjective estimate. LLC would like to know at what value for the chance of success of Aspen would the expected payoffs under the "proceed now" and "wait 6 months" options be equal. 

d) Suppose LLC could access a perfect forecast about Aspen's success/failure in the marketplace, how much should LLC be willing to pay for this forecast?