Question
EdDraycuttis the engineering manager of Airway Technologies, a firm that makes computer systems for air traffic control installations at airports. He has proposed a new
EdDraycuttis 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%.Eds device works with the A system and is a stroke of engineering genius.If the A system becomes the industry standard and Airway has Eds product, it will make a fortune before anyone else can market a similar device.
On the other hand if the A systemisntadopted, Airway will lose whatever its put into the new devices development.
Developing Eds 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.Youre 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 hed 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:
- EvaluateEds analysis. Does Ed have the right expected NPV? Whats wrong with his analysis?
- Suggestan approach that will give a more insightful result.
- Discusswhy the firm might consider passing on the proposal in spite of the tremendous NPV and IRR Ed has calculated?
- Evaluateif Eds case be might be helped by a real option. If so, what kind? How would it help?
Step by Step Solution
There are 3 Steps involved in it
Step: 1
Get Instant Access to Expert-Tailored Solutions
See step-by-step solutions with expert insights and AI powered tools for academic success
Step: 2
Step: 3
Ace Your Homework with AI
Get the answers you need in no time with our AI-driven, step-by-step assistance
Get Started