Canonical Decision Problem

Susan Smart, a recent graduate of MIT, has decided to start her own business, Frill Less Internet Provider (FLIP). She is offering small businesses and residential customers Internet access, providing a fast and convenient dial-up connection by modem. To start this business she must buy an Internet server, a special computer designed to bundle all incoming calls and establish the connection to the Internet backbone system. She is currently evaluating two different offers from the computer manufacturer Xentec, one for a X100 server for a price of $14,000 and another for a X120 server priced at $22,000. The most important factor for her investment decision is the peak number of subscribers one server can handle. A rule of thumb is that the peak capacity of the server should be 10% of the total number of subscribers. The number of subscribers Susan can take is constrained by the capacity of her server. The X100 has a capacity of 80 connections at peak level; the X120 can handle up to 140 connections. Thus, buying the X100 permits FLIP to take up to 800 subscribers, while the X120 allows a maximum of 1,400 customers. The problem is that Susan does not know how many customers she will attract with her new service. She believes that it is equally likely that she will attract 400 or 800 subscribers during the first year. If the demand is high in the first year she believes that there is a 50% chance of getting 1,200 subscribers during the second year and a 50% chance that demand will stay at 800. If the demand is low during the first year, there is a 50% chance that it will remain at 400 and a 50% chance that it will go up to 800. Susan plans to charge a $20 flat monthly fee to her subscribers, independent of the hours of usage. The variable costs of setting up the modem connection and monitoring the activities are expected to be $9 per month and customer. The total overhead expenses (salaries, office rent, etc.) are expected to be $6,000 per month.

Option to Abandon

If the demand turns out to be low after one year of operation,Susan might want to abandon the entire business. If she abandons the business, she can sell either X120 computer or the X100 at 40% of the original price. How does this option to abandon affect the initial investment decision?