Ed Draycutt is 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%.Ed’s device works with the A system and is a stroke of engineering genius.If the A system becomes the industry standard and Airway has Ed’s product, it will make a fortune before anyone else can market a similar device.
On the other hand if the A system isn’t adopted, Airway will lose whatever it’s put into the new device’s development.
Developing Ed’s 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.You’re 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 he’d 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:
1- Evaluate Ed’s analysis. Does Ed have the right expected NPV? What’s wrong with his analysis?
2- Suggest an approach that will give a more insightful result.
3- Discuss why the firm might consider passing on the proposal in spite of the tremendous NPV and IRR Ed has calculated?
4-Evaluate if Ed’s case be might be helped by a real option. If so, what kind? How would it help?