Question: Shu Mei Wang is going to start a new business to provide a geographical-information system (GIS) to be used by small businesses in selecting promotions and for other marketing applications.2 She will provide her service to on-line subscribers via a sophisticated Internet server. She is considering two alternative servers: the GZ1000, which will cost $21,000, and the GZ1450, priced at $33,000. The choice of server depends on the peak number of subscribers she will have. Standard practice is to plan the server capacity to be 10% of the number of subscription accounts. The GZ1000 has capacity for 80 connections and the GZ1450 for 140 connections. The number of subscriptions for the year will be settled within the first month of the year and continue for the entire year, but will not be settled before the server must be ordered.
Shu Mei expects that it is equally likely that her business will attract 400 or 800 accounts in the first year of operation. In the second year, there is a 50% chance that there will be 1,200 accounts and a 50% chance that accounts will stay at 800, if the number in the first year is 800. On the other hand, if there are 400 firstyear accounts, Shu Mei assesses a 50% chance that accounts will remain at 400 and a 50% chance that they will go up to 800 in the second year. The price per month per GIS client account will be $30 regardless of usage. The operating cost per account amounts to $13.50. Total fixed overhead for the business will be $9,000 per month. For simplicity, ignore time value of money and taxes for each option.
a. Should Shu Mei buy one GZ1000 or one GZ1450, based on expected profit over the first 2 years of operation? (Either server will have a useful life of 2 years and zero salvage value.)
b. Expand option: Shu Mei can decide in 1 year to expand the server operation. Suppose that the same GIS servers will be available 1 year from now at 40% of the original price on the resale market. Does her initial decision change?
c. Switch option: It might be a good idea for Shu Mei to sell her GZ1000 after 1 year and buy the discounted GZ1450, rather than buy another server. Would Shu Mei want to do this? What is the expected monetary value of this option? Assume resale value is 40% of original price.
d. Exit option: In the event that demand is low after one year, Shu Mei may just want to get out of the business. If she does, the original server would be salvageable at 40% of the original price. Does this option affect the initial investment decision?
e. Delay option: All these options and the inherent uncertainty have made Shu Mei nervous about the business. Perhaps she should delay for a year, observe the demand for her service, and then buy a used server (at the 40% discounted price) to capture the secondyear demand. Is this option attractive when compared with the other options?