A nationwide real estate corporation is consider­ing adding a new service line to sell the house of a client that buys another house through one of their agencies. It has determined that the first cost would be $80 million cash available for full implementation. However, John, the corporate vice president of sales, is not sure how well the service will be received, so he has projected added revenues using optimistic, most likely, and pessimistic estimates of $35 million, $25 mil­lion, and $10 million, respectively, with equal probability for each. Instead of expanding now, the company could implement a pilot program for 1 year in a limited geographic area that will cost $4 million now. (The full-scale service will still cost $80 million if im­plemented later.) This will provide the

Question

company with the option to move forward or cancel the proj­ect. The criterion identified to move ahead with full-scale implementation is that added revenues during the pilot program must exceed $900,000. In this case, the pessimistic estimate will be elimi­nated, and equal probability placed on the remain­ing revenue projections. If the company uses a 5-year planning horizon and a MARR of 12% per year, should the company go ahead with the full-scale service now or take the option to implement the pilot program for 1 year?

What will be an ideal response?

Answer 1

In $ million units,
PWInvest now = -80 + [35(0.333) + 25(0.333) + 10(0.333)](P/A,12%,5)
= -80 + [35(0.333) + 25(0.333) + 10(0.333)](3.6048)
= $4.028 ($4.028 million)

PWInvest later = -4 + 0.9(P/F,12%,1) – 80(P/F,12%,1) + [35(0.5) + 25(0.5)]
×(P/A,12%,4)(P/F,12%,1)
= -4 + 0.9(0.8929) – 80(0.8929) + [35(0.5) + 25(0.5)](3.0373)(0.8929)
= $6.732 ($6.732 million)

Conclusion: Company should implement the pilot option and delay the full-scale decision for 1 year