Description

Many of the capital budgeting example considered in class are simplified. We intentionally ignored many facets of reality, so that we can concentrated on one or two issues. Problems in the real world are more complex. This homework assignment is simple relative to many real world situations. This assignment gives you the opportunity to apply what you have learned about capital budgeting and real options to a more realistic, and therefore messier, situation.

This assignment will ask you to make a sequence of capital budgeting decisions. Each time you invest it costs money. However, the project is only successful with a small probability. This problem is more realistic than regular capital budgeting examples from class, in the sense that you do not know the true probability of success with certainty. If the project is successful, you will receive a large payoff. If the project is unsuccessful, the payoff is zero. However, following unsuccessful investments you have the option to invest again. You may continue investing until you are successful or until you decide that it is no longer makes sense to continue investing.

The final feature of the investment decision is you must decide whether to purchase the rights to the investment project. If you choose to purchase the investment project, you will then be asked whether you want to invest. After each unsuccessful investment round, you will be asked whether you want to invest again. After 30 unsuccessful investments, the program will stop and move you onto the next case. You will need to decide whether you should continue to invest or stop. You may want to use your knowledge of capital budgeting from Finance I, as well as any experience from your work experience which you think is relevant.

The program will run through eighteen independent examples. In each example, you will be given information on the investment project and asked whether you want to purchase the project. The information will include the purchase price of the project, the cost of each incremental investment, the payoff if the investment is successful, and the distribution for the probability of success. Only the cost of each incremental investment will remain constant across scenarios. It will always be $10. The other numbers will change across the scenarios. You will be told the two possible values of the true probability of success. For example, the probability of a successful investment may be 15% or 25% with equal probability. The actual probability of success will be one of these probabilities and will not change for the duration of the scenario. You, however, will not know which one is correct.(1) Each scenario is independent of the others

When you are finished the computer will store your results along with your. The computer will also ask you for a 7 digit ID number (which may be the end of your social security number or the ID number that the school now uses). Since I can not post your name with your homework score, I will post your answers by the last six digits of this number on the web page. I will also link your first and second trials using the id number. On your second trial, make sure you enter the same ID number as the first time. If there are problems with the program or you have questions about the assignment, please ask me. You must run the program twice. I will grade you on the correctness of your investment decisions --i.e. did you take only positive NPV projects. I will use take the maximum of your two scores in assigning a score for this homework.(2)

Footnotes:

  1. For those of you interested in the mechanics of the program, here is what the computer is doing. The computer will tell you that the true probability of success is 15% or 25% with equal probability, for example. Then, the computer will 'flip a coin'. If the coin comes up as heads (which is what happens 50% of the time), it will select 15% as the true probability of success. If the coin comes up as tails, it will select 25% as the true probability of success. You don't know what the true probability of success is. If the first coin came up heads, each time you choose to invest an additional time, the computer 'flips another coin,' which comes up heads 15% of the time. If the first coin came up as tails, each time you choose to invest an additional time, the computer 'flips another coin,' which comes up heads 25% of the time.
  2. If you do the homework only once, your score will be one half the score given on your first completion of the assignment. You should do the program exactly twice. I will consider it a violation of the honor code if you complete the homework under a fictitious name.