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4. Imagine that you are George Lucas, creator of Star Wars. You are trying to decide whether to film the next two Star Wars movies at the same time. If you film them both at once, you can save money on production costs, but you could lose a lot of money if the first one flops and no one goes to see the second one. Specifically, if you film them both at once, it will cost $250 million, but if you film them separately, they will cost $150 million each. If the first one is successful, it will have revenues of $1 billion and the second one will also have revenues of $1 billion. If the first one fails, it will only have revenues of $75 million and the second one will have revenues of only $25 million. If you decide to film them separately and the first one flops, you don't have to film the second one. The first film has a 50% chance of succeeding and a 50% chance of failing. Assume that all figures are given as present values (you do not need to do any additional discounting).
a. Should you film them both now or separately? Why? (6)
You should draw decision trees for this one. It's hard to render these things for HTML, so I'll just describe the trees. If you make them both at the same time, you will have an outflow of -$250 million for sure and a 50% chance of an inflow of $2 billion ($1 billion + $1 billion if the film is successful) and a 50% chance of an inflow of $100 million ($75 million + $25 million if the film flops). Thus, your expected NPV before you start is: -$250 million + 0.5($2000 million) + 0.5($100 million) = $800 million.
If you do them separately, then you will have a certain outflow of $150 million to film the first one. If it flops, you won't film the second one (since it will cost $150 million but only return $25 million). Thus, you have a 50% chance of getting $1 billion and then filming the second one (at a cost of $150 million) and then getting an additional $1 billion. You also have a 50% chance of only getting $75 million and then deciding to stop. Your expected NPV before you start is: -$150M +0.5($1000M - $150M + $1000M) + 0.5($75M) = $812.5M
You should do them separately because your expected NPV is higher. The flexibility of stopping is a valuable option.
The ability to choose adds value because you can change the course of the project after you have learned more about its profitability. This managerial flexibility is valuable in that it basically puts a floor on your losses since you can choose to stop if things go poorly.