Sonny Bono and a group of entrepreneurs have decided to get into the exciting world of smart phone application development. They have developed an ingenious idea for a business "app" and have done enough market research to know that their idea has market value. Having gone through Entrepreneurship at SFU, Sonny and his team are debating the size of the investment (and it related impact on the app developed) they are willing to put into the project. For a $10,000 investment, they will be able to produce a "simple" business app and launch the product. For a $30,000 investment, they can launch a far more "sophisticated" version of the product that has the potential for a much greater market place to the business world.
Sonny and his team understand the fact that market demand will influence their revenue stream. If they invest the smaller amount, the group conservatively estimates revenues in the first year of $40,000 or $55,000 depending on a "low" or "high" market demand respectively. Likewise, if they develop the more sophisticated app, they estimate revenues of $5,000 if there is "low" demand in the first year and $130,000 in revenues if there is "high" market demand.
In the absence of any hard data on market demand for the business app, the best Sonny and his team can guess is that there is a 40-60 chance the market demand will be low or high respectively.
a) Draw a decision tree by hand to help analyze this problem. Using the EMV decision criterion, what should they do?
b) Draw a decision tree using Treeplan.xla and provide a final concluding statement. State the Risk Profile of the optimal decision alternative.
c) Develop a sensitivity table showing how the overall optimal decision and the respective EMV may change if the probability of "low" market demand varies from 0% to 100% in steps of 10%. Assume the probabilities are collectively exhaustive between low and high market demand probabilities. Interpret the meaning of the output from the Data Table for Sonny.
Part II:
Sonny could request from a local research company, MMM (Max, Min and Mike) Enterprises Ltd., to conduct a survey at a cost of $9,000 that would better indicate whether market demand will be low or high in the first year. In discussion with MMM, Sonny has learned the following about the reliability of surveys conducted by the firm:
d) Develop a second decision tree for Sonny and his team to reflect this new option of hiring the research firm prior to the possibility of developing the app. Draw this decision tree by hand and evaluate it using the EMV decision criterion. Use the same cash flows provided in Part I. Provide a concluding statement with respect to Sonny's optimal decision.
e) Use Treeplan.xla to evaluate the decision tree in part d). State the Risk Profile of the optimal decision alternative. Print out your decision tree and include it with your submission.