Real Options and Valuation (20 points)

A product based on a new technology has two major potential markets. The dominant uncertainty associated with it has to do with the technology rather than the markets. Accordingly, the product will succeed in both or fail in both, with equal probability.The markets are otherwise independent and may be entered sequentially or simultaneously either now, one year from now, or two years from now.Market A requires an initial investment of $100 regardless of when it is entered.If the product is successful, market A will have a present value of $160 one year after entry.If the product fails, market A will be worth $80 one year after entry.Market B requires an initial investment of $55 regardless of when it is entered.One year after entry, B will have a present value of $140 or $25 for success and failure, respectively.For simplicity, perform all discounting in this problem at 5%.

Questions

1. (5 points) What is the NPV for each market, assuming each is entered immediately?

1. (5 points) Examine the possible combinations of time and place for introducing the new product. Can any possibilities be eliminated as suboptimal without further calculations? Why or why not? Which entry strategy is optimal?

1. (5 points) State a general capital budgeting rule for selecting the optimal strategy in this and similar problems.

1. (5 points) Suppose there are three potential markets, A, B, and C, where A and B are as above and C requires an investment of $40 regardless of when entered and will be worth either $55 or $40 one year later. Test the decision rule you formulated in part (c.) above to check that it produces the optimal decision for this revised problem.