Campus Crucible is an R&D company that purchases inventions from campus-based researchers and companies who do not have the means or desire to further to develop them. Campus recruits its own scientific or engineering teams to develop the inventions for commercial use, and then sells or licences them to other companies. It is currently in negotiations to buy a new invention that could significantly reduce the energy consumption of traffic lights. The invention seems to be more promising than existing technologies aimed at doing the same thing, and if Campus can buy the invention and succeed in developing it, they could make a profit.
Based on what Campus knows about the invention, it is 50% likely to have commercial potential (i.e. to be better than currently available competing ...view middle of the document...
5 million exploration costs, and not the €1m development costs.
However, Campus could conduct preliminary testing on the invention before buying it, to get a better indication of its likelihood of having commercial potential. The inventor has agreed to allow Campus to do this, but the preliminary testing will take two weeks to conduct and there is a 5% chance that the inventor will sell the invention to another buyer in that time period. If the inventor doesn’t sell the invention to another buyer, Campus will still be able to buy it for €2 million.
The preliminary testing will give Campus a clearer understanding of whether the invention has commercial potential, but the testing is not perfectly accurate. If the testing shows a positive result, there is an 80% chance that the invention has commercial potential and a 20% chance that it has no commercial potential. If the testing shows a negative result, then there is only a 30% chance that the invention has commercial potential and a 70% chance that it has no commercial potential. The cost of the preliminary testing is €0.25 million. In Campus Crucible’s experience, such preliminary testing shows a positive result only 40% of the time: in other words, there is a 40% chance that the testing will return a positive result and a 60% chance that it will return a negative result.
Therefore the preliminary testing does not give absolute certainty that the invention will have commercial potential. If Campus bought the invention it would still need to go through the whole process of exploring the commercial potential and developing the invention as described and costed earlier.
Campus Crucible must decide whether to conduct the preliminary testing, and indeed whether to buy the invention at all. Draw a decision tree to represent the problem and indicate what Campus should do if their objective is to maximise expected value. You may disregard taxes, inflation and the time value of money.