QUESTION 5
A company with an ageing product range is investigating the launch of a new range. Its business analysts have mapped out the following scenarios.
Scenario 1
Continue with the old range with profits declining at 10% per annum on a compounding basis. Profits from this range for the previous year totaled $60000.
Scenario 2
Introduce a new range without any prior market research. If sales are high, annual profit is put at $90000 with a probability of 0.7. If sales are low, annual profit is put at $30000, with a probability of 0.3.
Scenario 3
Introduce a new range with prior market research costing $30000. The market research will indicate whether future sales are likely to be "good" or "bad". If the research indicates "good", then the management will spend $35000 more on capital equipment and this will increase the annual profit to $100 000, provided sales are actually high. However, if sales are actually low, the annual profit will drop to $50 000. Should management decide not to spend more on promotion (given a good research report), then profit levels will be as for scenario 2. If the research indicates "bad", then management will scale down their expectations for an annual profit of $70000.
Probability calculations reveal the following information.
The probability of a favourable research report = 0.59.
The probability of high sales given a favourable research report = 0.95.
The probability of high sales given an unfavourable research report = 0.34.
With the aid of a decision tree prepare a quantitative report advising the company on the optimal course of action.
(Use a time horizon of 6 years and ignore the time value of money.)