Onofrio has failed to meet FDA requirements and will need to change the way it c

Question

Onofrio has failed to meet FDA requirements and will need to change the way it conducts its business. There are two mutually exclusive options under consideration by the company which will get the company back on track with meeting the FDA requirements, but will take the company in two very different directions. Option 1 has the company making all of the necessary corrections to their manufacturing processes to meet FDA requirements in order to continue producing their flu vaccine. Option 2 has the company completely rerouting their direction by producing drugs that fight cancer. Each project has an economic service life of 1 year with no salvage value. The initial cost and the net-year-end revenue for each project are given in the following table Option 1 $22,000 tion 2 $20,000 Initial Cost Probability | Revenue Probability Revenue $18,000 $22,000 $25,000 0.40 0.40 0.20 $20.000 $25,000 $28,000 0.30 0.40 0.30 Net Revenue given in PW Assuming both projects are statistically independent of each other, a. Calculate the expected value for each project b. Calculate the variance for each project. c. Which project should be chosen? Why?

Explanation / Answer

Option 1

Probabilty set = (0.4,0.4,0.2) & Revenue Set = (20000,25000,28000)

Exepcted Revenue for Option 1 = 0.4*20000+0.4*25000+0.2*28000 = 8000+10000+5600 = 23600

Hence Net Present Value for Option 1 Project = -22000+23600 = 1600

Similarly for Option 2

Probabilty set = (0.3,0.4,0.3) & Revenue Set = (18000,22000,25000)

Exepcted Revenune for Option 2 = 0.3*18000+0.4*22000+0.3*25000 = 5400+8800+7500 = 21700

Hence Net Present Value for Option 1 Project = -20000+21700 = 1700

To calculate the Variance of revenues of each project we have

Variance of revenue =(Expected value of (Revenue)^2) -(Expected Value of Revenue)^2-

Expected value of (Revenue)^2= Probability of Revenue 1*(Revenue 1)^2 + Probability of Revenue 2*(Revenue 2)^2 + Probability of Revenue 3*(Revenue 3)^2

= 0.4*(20000^2) +0.4(25000)^2+0.2(28000)^2 =(0.4*400+0.4*625+0.2*784)1000^2 = (160+250+156.8)*1000^2 = 566.8*1000^2

Expected Value of Revenue of Option 1^2 = (23600)^2 =556.96*1000^2

Variance of Revenue for Option 1 = (566.8-556.96)*1000^2 =9.84*1000^2

Standard Deviation is $ 3136.87 for Option 1

Expected value of (Revenue)^2= Probability of Revenue 1*(Revenue 1)^2 + Probability of Revenue 2*(Revenue 2)^2 + Probability of Revenue 3*(Revenue 3)^2

= 0.3*(18000^2) +0.4(22000)^2+0.3(25000)^2 =(0.3*324+0.4*484+0.3*625)1000^2 = (97.2+193.6+188.5)*1000^2 = 479.3*1000^2

Expected Value of Revenue of Option 2^2 = (21700)^2 =470.89*1000^2

Variance of Revenue for Option 2 = (479.3-470.89)*1000^2 =8.41*1000^2

Standard Deviation is $ 2900 for Option 2

As Net Present Vaule of Option 1 > Net Present Vaule of Option 2

Variance of Option1< Variance of Option 2

Hence Option 1 is feasible and should be chosen to Option 2

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