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.)