Finance on precision tree and risk profile

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Finance on precision tree and risk profile
Question 1
Phone-King has developed a new smart phone, but is considering investing 5M in R&D in an attempt to improve its functionality. Investing in R&D doesn’t guarantee success; however, the company believes that there is a 60% chance they will be able to produce a superior phone at the end of the process. Phone-King is also tasked with deciding the RRP (recommended retail price) per phone. Clearly, higher prices are likely to impact customer demand for phones. They anticipate the following distribution of demands given the type of phone and RRP:
Demand (units)
RRP ($/unit) 200K 300K 500K
Existing Model $120 0.10 0.20 0.70
$150 0.20 0.40 0.40
$200 0.60 0.30 0.10
Superior
Model $120 0.05 0.10 0.85
$150 0.10 0.20 0.70
$200 0.20 0.50 0.30
Assume that the profit margin of the company is 50% of sales revenue.
1. Describe the decision situation using a decision tree. (you can ignore the option of not marketing the phone at all).
2. What is Phone-King’s optimal policy if their goal is to maximise EMV? What is the EMV under this strategy.
3. Analyse the problem using the Stochastic Dominance criterion. Are your results consistent with Section 2? Only consider 2 courses of action: Invest in R&D and don’t invest in R&D (assume you choose the price optimally for each strategy).
4. What is the optimal policy if the firm wants to ensure that a profit of at least 25M dollars is achieved?
5. Assume that the company has a binding contract to sell its phones at $200 (regardless of the model). Should it invest in R&D?
6. What is the monetary cost of locking in a cost of $200 per phone?
Question 2
An investor is considering 3 potential projects with unknown returns. After a careful analysis, she has come up with the following estimates for the Net Present Value of the three investments under consideration.
Investment 1 Investment 2 Investment 3
Probability NPV Probability NPV Probability NPV
0.3 800 0.2 900 0.2 700
0.4 400 0.2 500 0.3 500
0.3 200 0.4 400 0.3 400
0.2 300 0.2 300
You have been tasked with ranking the investments in terms of attractiveness for the investor. Write a short report justifying your ranking of the three investments.

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