The company is evaluating whether or not to invest in R&D to develop a new medical device. Starting today, three years of R&D would be required for product development and testing. (Note: The company recognizes R&D expenditures at the beginning of each year). At the end of the third year, if R&D results are encouraging, a $60 million capital investment in manufacturing facilities would be required to produce the device. It is estimated that net cash inflows would then be received for seven years from sales of this product. These net income estimates, however, are highly speculative and the volatility surrounding these values is 50%. (Note: The company recognizes net income at the end of each year). Companys actual cash flow projections are shown below. The Companys nominal risk-adjusted MARR is 15% p.a. The yield on 10-year Treasury bonds is about 4% p.a. Using a Real Options analysis, determine if the required R&D spending is justified. (Approaching this problem: Companys R&D expenditures are, in effect, purchasing a call option which, if test marketing proves favorable, would be exercised at EOY 3 when they elect to invest in the manufacturing facility. If test marketing proves unfavorable, they would not exercise this option and the new medical device project would be terminated.

15 20 25 15 A 25 20 A 15 10 3 5 6 ($ Millions) 60