Question

6. Decision Trees.  Ang. Electronics, Inc., has developed a new HD DVD.  If the HD DVD is successful, the present value of the payoff (at the time the product is brought to market)is $29 million.  If the HD DVD fails, the present value of the payoff is $8.5 million.  If the product goes directly to market, there is a 55 percent chance of success. Alternatively, the company can delay the launch by one year and spend $1.4 million to test-market the HD DVD.  Test-marketing would allow the firm to improve the produce and increase the probability of success to 75 percent.  The appropriate discount rate is 11 percent.  Should the firm conduct test-marketing?  

Answer 1

Probability of success = 0.55

Probability of failure = 1 - 0.55 = 0.45

NPV if product goes directly to market = 0.55*(29,000,000) + 0.45*(8,500,000)

NPV if product goes directly to market = 15,950,000 + 3,825,000

NPV if product goes directly to market = $19,775,000

NPV if conducted testing = -1,400,000 + [0.75*(29,000,000) + 0.25*(8,500,000)] / (1 + 0.11)

NPV if conducted testing = -1,400,000 + [21,750,000 + 2,125,000] / 1.11

NPV if conducted testing = -1,400,000 + 21,509,009.01

NPV if conducted testing = $20,109,009.01

Firm should conduct testing as it has a higher NPV