Comparison: Critical Probabilities

What is the expected NPV in each case? Compare the expected NPV using the traditional NPV approach with the expected NPV using real options. What do you recommend? Why? What do you conclude in each case?

If you don't know the probability of success for the pilot, is there a valuethat is critical to your recommendation? Is there a probability of success above or below which you will recommend undertaking the pilot and below or above which you will recommend a go/ no go decision on the underlying project without undertaking a pilot test?

Breakeven Probability: If we knew the probability of the full project's success to be 1.0 (i.e., a guaranteed success), we wouldn't go the pilot project route -- why waste $10 million? Therefore, there must be a breakeven probability of success that would render the pilot project irrelevant. We can find that probability by equating the present values of the full project and the pilot.

Critical Probability of Success with the Pilot: We can calculate the critical probability for going ahead with the pilot by setting the PV expression = 0 and solving for X.

Go / No Go Probability. Probability of Success without Pilot: If we have no real option, the breakeven probability for go/ no go comes from solving another similar equation. (You must find it.)

Label your work as follows:

Part 3: Critical Probabilities

1. Probability to forget the Pilot and complete the Project.

2. Probability of going ahead with the Pilot.

3. Go / No Go Probability.