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A professor in the Computer Science department at United States Institute of Technology has just patented a new search engine technology and would like to sell it to? you, an interested venture capitalist. The patent has a? 17-year life. The technology will take a year to implement? (there are no cash flows in the first? year) and has an upfront cost of $100 million. You believe this technology will be able to capture 1.05% of the Internet search? market, and currently this market generates profits of $1 billion per year. Over the next five? years, the? risk-neutral probability that profits will grow at 10.1% per year is 20% and the? risk-neutral probability that profits will grow at 5.1% per year is 80%. This growth rate will become clear one year from now? (after the first year of? growth). After five? years, profits are expected to decline 2% annually. No profits are expected after the patent runs out. Assume that all? risk-free interest rates are constant? (regardless of the? term) at 10.1% per year.
Problem a. Calculate the NPV of undertaking the investment today.
Problem b. Calculate the NPV of waiting a year to make the investment decision.
Problem c. What is your optimal investment? strategy?
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