Question

Ang Electronics, Inc., has developed a new DVDR. If the DVDR is successful, the present value of the payoff (when the product is brought to market) is $24 million. If the DVDR fails, the present value of the payoff is $8.5 million. If the product goes directly to market, there is a 50 percent chance of success. Alternatively, the company can delay the launch by one year and spend $1.2 million to test market the DVDR. Test marketing would allow the firm to improve the product and increase the probability of success to 80 percent. The appropriate discount rate is 11 percent.

Required:
Calculate the NPV of going directly to market and the NPV of test marketing before going to market.

Answer 1

NPV of going directly to the market:

Expected value of future cash flows = ($24 x 50%) + ($8.5 x 50%) = $16.25 million

There is a 50/50 chance of being a success or a failure, so to determine the expected value you just multiply each option by 50% and add them.

NPV of test marketing before going directly to the market:

Expected value of future cash inflows = ($24 x 80%) + ($8.5 x 20%) = $20.9 (but delayed by 1 year)

PV of expected cash flows = -1.2 (marketing costs) + $20.9/1.11 = $17.80 million