Case Study 2 : Strenlar

Do a complete analysis of Fred’s decision. Your analysis should include at least structuring the problem with an influence diagram, drawing and solving a decision tre, creating risk profiles and checking for stochastic dominance. What do you think Fred should do? Why? We assume the following : i. ii. iii. iv. v. The sales are evenly distributed for 10 years. Average yearly sales is $ 35 million / 10 = $ 3.5 million Yearly discount rate = 0.1 All payoffs in the decision tree are Net Present Value. Yearly salary for working in companies other than PI is $ 30,000

Influence Diagram

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Outcome:

L1: Win L2: Lose L3: No Lawsuit Lawsuit

Outcome: P1: Success P2: Failure Product: Success or Failure?

Decision: Accept or refuse? D1: Salary + Royalty D2: Cash + Stock Options D3: Refuse

Profits

The Strenlar case study required substantial modeling. Use sensitivity analysis to refine your model. In particular, you might consider the interest rate used to calculate net present value, legal fees, the eventual price of PI’s stock, Strenlar’s gross sales, Fred’s profits if Strelnlar is successful, the probability of Strenlar being successful and the probability of winning the lawsuit. So you think that Fred’s decision is sensitive to any of these variables? Try wiggling one variable at a time away from its base value while holding everything else at base value. How much can you wiggle the variable before the decision changes? At the end of your analysis, discuss your results and the implications for

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Fred’s decision model. If he were to refine his model, what refinements should he make? Decision Tree

Salary + Royalty D1 $ 1.33m

S1 (0.8) $ 1.6 million

S2 (0.2)

$ 0.30 million

S1 (0.8) D2 $ 1.26m S2 (0.2)

$ 1.41 million

$ 2.24m

$ 0.68 million S1 (0.8) $ 4.71 million $ -0.015 million

L1 (0.6) D3 $ 2.24m Refuse the Offer L2 (0.4) S2 (0.2)

$ -0.035 million

Decision 1( Salary + Loyalty) PI Salary: $50,000 p.a. Royalty: 6% of 35m over 10 years. Debit payment of $200,000 taken care of by PI. Annual Salary = $ 50000 Annual Royalty = 0.06*3,5m = $ 0.21m
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Annual cash flow = $0.26 m Success: NPV of future stream of income =
0.26m 0.26m 0.26m + + ... + = $1.6m 2 1.01 1.01 1.0110

Failure: NPV of salaries over 10 years =
0.05m 0.05m 0.05m + + ... + = $0.307m 2 1.01 1.01 1.0110

Decision 2 (Cash + Stock Options): Lump Sum Payment: $500,000. Stock Option: 70,000 shares @ $40/share ($52 vs. $39/share 18 months from now). Debit payment of $200,000 taken care of by PI. Success, NPV of stock option profit =
70000 *12 = $904,420 1.011.5

Hence, total NPV of cash received = 500,000 + 904,420 = $1.40m Failure, NPV of total cash received = $500,000 =$ 0.5m Refuse the Offer: Profits: $8,000,000 over 10 years if win the case. Legal Fees: $20,000 if lose the case. Debit: $200,000 payment to the creditors. Case won and product succeeds, NPV of $8m received over 10 years minus debt taken with interest of 1% (debt is repaid after 3 years of it issue) =
0.8m 0.8m 0.8m + + .. + − 200,000 * (1.01) 3 = $4.7m 2 1.01 1.01 1.0110

Case won and product fails,
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Legal fees are paid by PI. However, Fred still has to return the money to the creditors. Hence, NPV = $ -0.015m If the lawsuit is lost, Total cost incurred = legal fees + money owed to creditors with interest NPV of the total cost = $ -0.035m

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