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BUS9040M: Decision Analysis for Managers
Assignment 3: Case Study – BMAC Research & Development Decision (Part 2)
| Note: Please do make sure that you appropriately cite any reference material, using Harvard Referencing style and ensure that you draw from quality academic sources. On this note, remember that general internet sources such as Wikipedia and Investopedia are not recognised academic sources. |
In this assignment, you will continue with the analysis of the BMAC research & development
(R & D) case study from assignment 2. For ease of reference, a copy of the case study is
provided in the box below.
| Case study: BMAC Research & Development decision BMAC, a research and development (R & D) company, must decide whether to spend $5 million to continue with a particular drug development research project. The success of the project (as measured by obtaining a patent) is not assured, and at this point the decision maker judges only a 60% chance of getting the patent. If the patent is awarded, the company can either license the patent for an estimated $30 million or invest an additional $20 million to create a production and marketing system to sell the product directly. If the company chooses the latter, it faces uncertainty of demand (categorized as high, medium or low demand) and associated profit from sales. The probabilities of the three levels of demand and associated revenues are summarised on the Table below.
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Revisit the BMAC research & development (R & D) decision case study above and continue
your analysis by addressing the following questions (no strict word limits as this assignment
mainly involves figures/calculations, except question 3. As a guide, approximately 200 words
in question 3).
Now consider a more realistic scenario for BMAC in which the costs and revenues, if they
decide to continue with the project, will be spread out over time. In particular, if BMAC decides
to continue the project, they will have to come up with the $5 million this year (Year 1). Then
there will be a year of waiting (Year 2) before they know if they are successful (that is, the
patent is granted). If they decide to license the technology, they would receive the $30 million
distributed as $6 million per year beginning in Year 3. On the other hand, if they decide to sell
the product directly, they will have to invest $10 million in each of Years 3 and 4 (to make up
the total investment of $20 million). Their net proceeds from selling the product, then, would
be evenly distributed over years 5 through 9. Based on this information, answer the following
questions.
(1) Now modify your decision tree (from assignment 2, question 1) to take account of the
time value of money (that is, replace net revenues with NPVs). (include your modified
decision tree in your submission)
Guidance:
Assume a discount rate of 13% and calculate the Net present value (NPV) at the end of
each branch of the decision tree. To obtain the NPVs at the end of each branch of the
decision tree, organize your answer on an excel spreadsheet using the template below
(see Appendix 1 below) – include a copy/paste screenshot of your completed excel sheet
(Appendix 1) in your answer for this part of the assignment. Note: Put zeros on the
spreadsheet cells for those years where there are no cash flows. Also note that, when
calculating the NPV, all cash flows start from year 1 (i.e., no initial cash flow at year 0)
– see lecture topic 2 and seminar 3 for guidance on calculating NPV in Excel.
(2) Using your (modified) decision tree (from 1 above) and the folding back the tree
procedure, calculate the discounted expected monetary value (EMV) of the two options
at the root of the BMAC’s decision problem i.e. (A) Continue with the R &D project at a
cost of $ 5 Million or (B) Stop R & D project at no cost. Based on your discounted EMV
solution, which alternative or strategy should BMAC pursue in order to maximize their
NPV? (two answers are required here i.e. discounted EMV and your recommended
alternative or strategy for BMAC)
(3) Compare/contrast the EMV and your recommended strategy for BMAC that you arrived
at in assignment 2 (question 2) with the discounted EMV and recommended strategy
obtained in question 2 above and briefly discuss the implications of taking account of the
time value of money through discounting, generally on project appraisal and particularly
in the case of BMAC.
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Appendix 1: Template for calculating NPVs in Excel
| Discount rate | All values are in millions of dollars | |||||
| 13% | ||||||
| Yearly Cash Flows |
Stop | Continue No Patent |
Continue Patent License |
Continue: Patent: Develop: Demand: High |
Continue: Patent: Develop: Demand: Medium |
Continue: Patent: Develop: Demand: Low |
| 1 | ||||||
| 2 | ||||||
| 3 | ||||||
| 4 | ||||||
| 5 | ||||||
| 6 | ||||||
| 7 | ||||||
| 8 | ||||||
| 9 | ||||||
| NPV |