Question

A company has developed a new gadget. If the gadget is successful, the present value of the payoff (at the time the product is brought to market) is $6.2 million. If the gadget fails, the present value of the payoff is $1.80 million. If the gadget goes directly to market, there is a 50 percent chance of success. Alternatively, the company can delay the launch by one year and spend $0.25 million to test-market the product. Test-marketing would allow the company to improve the product and increase the probability of success to 75%. The appropriate discount rate is 11%. Should the firm conduct test-marketing?

a. No, because NPV is lower by $0.25 million
b. No, because NPV is lower by approximately $0.31 million
c. No, because NPV is lower by approximately $0.11 million
d. Yes, because NPV is higher by approximately $0.34 million
e. Yes, because NPV is higher by approximately $0.19 million

Answer 1

d. Yes, because NPV is higher by approximately $0.34 million

Step-by-step explanation:

Calculation to determine whether the firm should conduct test-marketing

Calculation for Going directly to market:

Since there is a 50 percent chance of success First step is to calculate the Probability of failure

Probability of failure = 100% - 50%

Probability of failure = 50%

Now let calculate the NPV of going directly to market

NPV of going directly to market = 50% * $6.2 million + 50% * $1.80 million

NPV of going directly to market =$3,100,000+$900,000

NPV of going directly to market = $4,000,000

Calculation for Test marketing before going to market:

Since the probability of success is 75 percent the first step is to calculate the Probability of failure

Probability of failure = 100% - 75%

Probability of failure= 25%

Second step is to calculate Year 1 value

Year 1 value = 75% * $6.2 million + 25% * $1.80 million

Year 1 value=$4,650,000+$450,000

Year 1 value = $5,100,000

Now let calculate the NPV of test marketing before going to market

NPV of test marketing before going to market = $5,100,000 /(1 + 11%) - $250,000

NPV of test marketing before going to market=$4,344,595

Therefore based on the above calculation the firm should conduct test-marketing before going to the market because the NPV is higher by approximately $0.34 million ($4,344,595-$4,000,000)