A firm is considering launching a new product. Launching the product will require an investment of $10 million (including marketing expenses and the costs of new facilities). The launch is risky because demand could either turn out to be low or high. If the firm does not launch the product, its payoff is 0. Here are its possible payoffs if it launches the product.

a) Draw a decision tree showing the decisions that the company can make and the payoffs from following those decisions. Carefully distinguish between chance nodes and decision nodes in the tree. [5 marks]
b) Assuming that the firm acts as a risk-neutral decision maker, what action should it choose? What is the expected payoff associated with this action?

Question

A firm is considering launching a new product. Launching the product will require an investment of $10 million (including marketing expenses and the costs of new facilities). The launch is risky because demand could either turn out to be low or high. If the firm does not launch the product, its payoff is 0. Here are its possible payoffs if it launches the product.

a)      Draw a decision tree showing the decisions that the company can make and the payoffs from following those decisions. Carefully distinguish between chance nodes and decision nodes in the tree.    [5 marks]
b)      Assuming that the firm acts as a risk-neutral decision maker, what action should it choose? What is the expected payoff associated with this action?

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