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Practice problem--it's very helpful ~

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Department
Economics
Course Code
ECO359H5
Professor
Sun

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ECO359/2011UniversityofToronto
PracticeProblems3  DepartmentofEconomics
1
ECO 359 Practice Problems 3
Solutions to selected Textbook questions
Question 9.1
PR Electronics Inc. has developed a new Pink-Ray DVD. If the Pink-Ray DVD is successful, the present
value of the payoff (when the product is brought to the market) is $20 million. If the Pink-Ray DV fails,
the present value of the payoff is $5 million. If the product goes directly to the market, there is a 50%
chance of success. Alternatively, PR can delay the launch by one year and spend $2 million to test market
of the Pink-Ray DVD. Testing market would allow the firm to improve the product and increase the
probability of success to 75%. The appropriate discount rate is 15%. Should the firm conduct test
marketing?
Answer: Plot the tree diagram of the real options as follows:
Calculate the NPV of the expected payoff for the option of going directly to market.
NPV (Go Directly) = CSuccess (Prob. of Success) + CFailure (Prob. of Failure)
= $20,000,000 (0.50) + $5,000,000 (0.50)
= $12,500,000
The expected payoff of going directly to market is $12,500,000.
The test marketing requires a $2 million cash outlay. Choosing the test marketing option will also delay
the launch of the product by one year. Thus, the expected payoff is delayed by one year and must be
discounted back to year 0.
NPV (Test Market) = –C0 + [CSuccess (Prob. of Success)] / (1+r) + [CFailure (Prob. of Failure)] / (1+r)
= –$2,000,000 + [$20,000,000 (0.75)] / (1.15) + [$5,000,000 (0.25)] / (1.15)
= $12,130,434.78
The expected payoff of test marketing the product is $12,130,434.78. PR Electronics Inc. should go
directly to market with the product since that option has the highest expected payoff.
Question 9.3
B&B has a new baby powder ready to market. If the firm goes directly to the market with the product,
there is only a 55% chance of success. However, the firm can conduct customer segment research, which
will take a year and cost $1 million. By going through research B&B will be able to better target potential
customers and will increase the probability of success to 70%. If successful, the baby powder will bring a
Year1
Now(year0)
TestMarketr2M
50%
50%
25%
75% 20M
20M
5M
5M
Godirectly
Start
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Description
ECO3592011 UniversityofToronto PracticeProblems3 DepartmentofEconomics ECO 359 Practice Problems 3 Solutions to selected Textbook questions Question 9.1 PR Electronics Inc. has developed a new Pink-Ray DVD. If the Pink-Ray DVD is successful, the present value of the payoff (when the product is brought to the market) is $20 million. If the Pink-Ray DV fails, the present value of the payoff is $5 million. If the product goes directly to the market, there is a 50% chance of success. Alternatively, PR can delay the launch by one year and spend $2 million to test market of the Pink-Ray DVD. Testing market would allow the firm to improve the product and increase the probability of success to 75%. The appropriate discount rate is 15%. Should the firm conduct test marketing? Answer: Plot the tree diagram of the real options as follows: Now(year0) 50% 20M Year1 Godirectly 5M 50% Start 75% 20M TestMarket H2M 5M 25% Calculate the NPV of the expected payoff for the option of g
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