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ADVANCED CONTROLS CORPORATION DECISION TREE PROBLEM L. Schall

Advanced Controls Corporation (ACC) is now (at time 0) evaluating a proposal to develop an energy-saving water heater control valve. The Engineering Department believes that an expenditure of $200,000 will result in a new valve design that offers significant benefits over products currently on the market. The design development effort will take one year. Three outcomes one year from now (at time 1) are possible. There is a 30 percent probability that a workable product will be designed and that the design will be patentable so that its novel features can be protected from copying by other valve manufacturers. There is a 50 percent probability that a workable product will be designed but that it will be unpatentable. Finally, there is a 20 percent probability that the project will be completely unsuccessful, with no workable design being developed. The risk associated with design development is high enough to require a 20 percent discount rate for discounting the time 1 outcome of the design effort back to time 0. If the new valve design is developed, whether or not the design is patentable, a decision will have to be made at time 1, one year from now, as to whether it should be manufactured and how. The manufacturing facility, if constructed, will be built at time 1. Two facility designs are feasible. The larger and more efficient facility will require an initial investment of $3 million; it will offer significant cost savings if operated near capacity. A smaller and less efficient facility could be built with an initial investment of only $1.6 million; it would be more economical for low output levels. Market acceptance for the valve is highly uncertain. ACC will not know the final demand for the valve until it has been placed on the market at time 2 (two years from now). Although risks will be present throughout the life of the facility, much of the initial uncertainty will have been resolved at time 2. Management believes that the appropriate discount rate to reflect the risk of the initial market uncertainty is 15 percent, and so a 15 percent discount rate will be appropriate for discounting the time 2 outcome back to time 1. ACC management has estimated the time 2 present values of the net cash flows occurring after time 2 under various assumptions about the type of plant built at time 1 ($1.6 million plant or $3.0 million plant) and the demand conditions at time 2 (high or low). These estimates are shown in the table below. As of time 0, the time 2 high and low demand conditions are considered to be equally likely. Exhibit 1. Time 2 Present Value ( PV2 ) for Various Plant/Demand Scenarios Facility decision $1.6 mil. $3.0 mil. plant plant Patented design, high demand $5.0 mil. $10.0 mil. Patented design, low demand $2.4 mil. $3.2 mil. Unpatented design, high demand $3.0 mil. $5.5 mil. Unpatented design, low demand $0.8 mil. $1.3mil

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(a) Should the design development effort be undertaken? Develop a decision tree diagram of ACCs problem, and a second diagram that shows the results of your analysis of the decision tree.
(b) Change the facts in (a). Suppose that, because of zoning requirements and Federal

regulations, ACC may only build a $1.6 million plant. Proceed as you did in (a) and establish whether ACC should undertake the design development effort. How much better off is ACC under the conditions in (a) than under the conditions in (b)? That is, how valuable to ACC is the added flexibility under (a) relative to (b)? (c) What does this problem suggest about the value of flexibility and about how to measure it?
(d) Assume the situation in (a) but suppose that the capital budgeting analyst overlooked

managements ability to choose the $3.0 million plant at time 1. For example, suppose that George Cavil, the capital budgeting analyst, incorrectly assumed that the $1.6 million plant would be built if a patented or unpatented design were produced? Would this lead to an incorrect decision by ACC regarding whether to undertake the water heater design development? (e) Is there an acceptable alternative to decision tree analysis? What is it?

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SOLUTION (a) The original problem is depicted in the table below. Table 1. Decision Tree with Plant Choice Flexibility (Using Exhibit 1) Time = 0 (now) ______________ Time 0 Decision ______________ Time = 1 ______________ ______________ Time 1 Result of Design Time 1 Development Decision ______________ ______________ Build $3.0 mil. plant Patented design (p = .3) Build $1.6 mil. plant Do not build plant Undertake design development ($.2 mil.) Build $3.0 mil. plant Unpatented design (p = .5) Build $1.6 mil. plant Do not build plant No design (p = .2) Do not undertake design development ($0) High (p = .5) Low (p = .5) High (p = .5) Low (p = .5) $5.5 mil. $1.3 mil. $3.0 mil. $0.8 mil. 0 Time = 2 ______________ ______________ Time 2 Market Time 2 Present Demand Value ( PV2 ) ______________ ______________ High (p = .5) Low (p = .5) High (p = .5) Low (p = .5) $10.0 mil. $3.2 mil. $5.0 mil. $2.4 mil. 0

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Now determine the optimal decision at time = 1 for each possible outcome of the development effort. PATENTED DESIGN. Discount rate = 15%. Expected time 2 present value E[ PV2 ]. Net Present Value at time 1 NPV1 . If patented design and $3.0 mil. plant: E[ PV2 ] = $10.0 mil. (.5) + $3.2 mil. (.5) = $6.6 mil.
NPV1 = $6.6 mil. (1/1.15) $3.0 mil. = $2.74 mil.

(1a) (1b)

If patented design and $1.6 mil. plant: E[ PV2 ] = $5.0 mil. (.5) + $2.4 mil. (.5) = $3.7 mil.
NPV1 = $3.7 mil. (1/1.15) $1.6 mil. = $1.62 mil.

(1c) (1d)

Since the NPV1 of the $3.0 mil. plant ($2.74 mil.) is greater than the NPV1 of the $1.6 mil. plant ($1.62 mil.) and greater than 0, the best decision at time 1 is to build the $3.0 mil. plant if the design can be patented. UNPATENTED DESIGN. Discount rate = 15%. Expected time 2 present value E[ PV2 ]. Net Present Value at time 1 NPV1 . If unpatented design and $3.0 mil. plant: E[ PV2 ] = $5.5 mil. (.5) + $1.3 mil. (.5) = $3.4 mil.
NPV1 = $3.4 mil. (1/1.15) $3.0 mil. = $0.04 mil.

(2a) (2b)

If unpatented design and $1.6 mil. plant: E[ PV2 ] = $3.0 mil. (.5) + $0.8 mil. (.5) = $1.9 mil.
NPV1 = $1.9 mil. (1/1.15) $1.6 mil. = $.052 mil.

(2c) (2d)

Since the NPV1 of the $1.6 mil. plant ($.052 mil.) is greater than zero, and greater than the NPV1 of the $3.0 mil. plant ( $0.04 mil.), the best decision at time 1 is to build the $1.6 mil. plant if the design cannot be patented.

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The reduced diagram below is the result of the analysis performed up to this point.
Table 2. The Reduced (from Table 1) Decision Tree Time = 0 Time 0 Decision Time 1 Result of Design Development _______________ Patented design (p = .3) Undertake design development ($.2 mil.) Unpatented design (p = .5) No design (p = .2) Time = 1

____________ ________________________________________
Time 1 Decision ________________ Build $3.0 mil. plant Build $1.6 mil. Plant -NPV1 __________________ $2.74 mil. $0.052 mil. $0

________________

Do not undertake ($0)

In analyzing the development decision, discounting the time 1 results back to time 0 requires a 20% discount rate. Expected time 1 net present value E[ NPV1 ]. Net Present Value at time 0 NPV0 . The expected present value at time 1 from undertaking the design equals: E[ NPV1 ] = $2.74 mil. (0.3) + $(0.052 mil.) (.5) + $0 (.2) = $0.822 mil. + $0.026 mil. = $0.848 mil. The time 0 net present value of undertaking the design development equals:
NPV0 = $0.848mil (1/1.2) $.2 mil.

(3)

= $.848 mil. (0.8333) $.2 mil. = $.507 mil.

(4)

Since the NPV of the undertaking the design development ($.507 mil.) is greater than zero, undertake the development.

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(b) The new decision tree is as follows. Table 3. Decision Tree with County Approval Process (Using Exhibit 1) Time = 0 Time = 1 Time = 2 ___________ ______________________________________ ________________________ Time 1 Result Time 2 Time 2 Time 0 of Design Time 1 Time 1 Market Present Decision Development Decision Outcome Demand Value ( PV2 ) ___________ ___________ ___________ ___________ ___________ ___________ Build Patented design (p = .3) Do not build Do design development ($.2 mil.) Build Unpatented design (p = .5) Do not build 0 No design (p = .2) Do not do design dvlpmnt. ($0) Build $1.6 mil. plant High (p = .5) Low (p= .5) $3.0 mil. $0.8 mil. 0 Build $1.6 mil. plant High (p = .5) Low (p = .5) $5.0 mil. $2.4 mil.

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Now to determine the optimal decision at time = 1 for each possible outcome of the development effort. PATENTED DESIGN. Discount rate = 15%. Expected time 2 present value E[ PV2 ]. Net Present Value at time 1 NPV1 . If the $1.6 million plant is built, the following holds: E[ PV2 $1.6 mil. plant required] = $5.0 mil. (.5) + $2.4 mil. (.5) = $3.7 mil. (5a)
NPV1 $1.6 mil. plant

= $3.7 mil. (1/1.15) $1.6 mil. = $1.62 mil.

(5b)

So, if a patented design results, the time 1 net present value of building the $1.6 million plant is $1.62 million. So, ACC should build the $1.6 million plant if a patented design is produced. UNPATENTED DESIGN. Discount rate = 15%. Expected time 2 present value E[ PV2 ]. Net Present Value at time 1 NPV1 . If the $1.6 million plant is built, the following holds: E[ PV2 $1.6 mil. plant required] = $3.0 mil. (.5) + $.8 mil. (.5) = $1.9 mil.
NPV1 $1.6 mil. plant = $1.9 mil. (1/1.15) $1.6 mil. = $.052 mil.

(6a) (6b)

So, if an unpatented design results, the time 1 net present value of building the $1.6 million plant is $.052 million. So, ACC should build the $1.6 million plant if an unpatented design is produced.

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Table 4. The Reduced (from Table 3) Decision Tree with County Approval Process Time = 0 Time = 1

____________ Time 0 Decision

________________

_____________________________________ Time 1 Result of

Design Development _______________ Patented design (p = .3) Time 1 Decision ________________ Build the $1.6 million plant NPV1 ______________ $1.62 mil.

Undertake design Development ($.2 mil.) Unpatented design (p = .5) No design (p = .2) Do not undertake ($0) Build the $1.6 million plant -$.052 mil. $0

In the problem, we assumed a 20% risk-adjusted discount rate for discounting the time 1 results back to time 0. Expected time 1 net present value E[ NPV1 ]. Net Present Value at time 0 NPV0 . The expected present value at time 1 from undertaking the design is: E[ NPV1 ] = $1.62 mil. (.3) + $(.052 mil.) (.5) + $0 (.2) = $0.486 mil. + $0.026 mil. = $0.512 mil. The time 0 net present value of undertaking the design development equals:
NPV0 = $0.512 mil. (1/1.2) $.2 mil.

(7)

= $.512 mil. (.8333) $.2 mil. = $.227 mil.

(8)

Since the NPV of the undertaking the design development ($.227 mil.) is greater than zero, undertake the development. Now compare the results in questions (a) and (b). The time 0 net present values were:
NPV0 case (a) = $.507 mil. NPV0 case (b) = $.227 mil.

(9a) (9b)

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So, the greater flexibility in (a) relative to (b) adds $280,000 of gain in present value terms ($280,000 = $507,000 $227,000). (c) Flexibility adds substantial value if provides a high probability of a much better outcome. In case (b), the firm could not build the $3 million plant; and, with the patented design outcome (probability = .3), the firm would have to build the $1.6 million plant having an NPV1 of $1.62 million. In case (a), the firm could build the $3 million plant; and, with the patented design outcome, the firm would build the $3 million plant producing an NPV1 of $2.74 million. So, going from case (b) (no flexibility to build the $3 million plant) to case (a) (flexibility to build the $3 million plant) means a .3 probability of getting an extra time 1 NPV of $1.12 million ($1.12 million = $2.74 million $1.62 million). As we found, the increased flexibility raised the time 0 NPV of the research project from $227,000 to $507,000 (see (9a) and (9b) above). Notice that, if the $10 million in Exhibit 1 and Table 1 were changed to $8 million, NPV1 in equation (1b) would be $1.87 million, and NPV0 in (9a) would be $.288 million (you can go through the numbers to confirm this). In this case, the advantage of building the $3 million plant with a patented design outcome is much less than with the $10 million in Exhibit 1, and the value of the flexibility is only $61,000 rather than $280,000 ($61,000 = $288,000 $227,000). (d) Cavils incorrect analysis produces an NPV0 of $.227 million (as in (9b) above), which is positive and therefore indicates undertaking the design development (the correct decision since the true NPV0 = $.507 million > 0). But that does not justify the incorrect analysis for at least two reasons. First, an incorrect NPV computation distorts a comparison of the design development with other options and can lead to the wrong choice. For example, suppose that the firm were choosing between the design development and a Project Q. If the NPV0 of project Q were $.3 million, the design development should be chosen over Project Q (since $.507 million > $.3 million) but Cavils incorrect design development analysis producing the NPV0 of $.227 million would indicate that Q should be chosen (since $.3 million > $.227 million). Second, an incorrect analysis can lead to a negative NPV0 result even when NPV0 correctly computed is positive. For example, change the cost of the design development from $.2 million to $.5 million but leave all the other data in (a) and (b) the same. In question (a), the correct new result would be NPV0 = $.207 million (indicating that the design development should proceed). However, Cavils incorrect analysis would produce NPV0 = $.073 million (leading to the wrong decision to reject the development design project because $.073 million < 0). (e) A valid alternative to decision tree analysis is real options analysis. Relative to decision tree analysis, real options analysis makes it easier to estimate the discount rate, but is much less general and less able to deal with complex decision situations. Other than real options, there is no accepted alternative for factoring in managerial flexibility in computing NPV.

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