NPV and RA analyses: new product development New product development processes typically involve a multi-year, sequential set of milestones and ‘go’ or ‘no go’ decisions. The following table contains data relevant to a specific new product project. Consider the prospects for a new product that must proceed through the following representative milestones and decisions:

● Step 1. Invest in R&D (yes or no).

● Step 2. If yes, evaluate success of R&D, typically after two years. If no, earn the cost of capital on funds not invested.

● Step 3. If R&D is unsuccessful, terminate the project. If the R&D is successful, commercialise the product or conduct market research (a test market). Commercialisation or test marketing typically takes one year of activity.

● Step 4. If commercialisation is the outcome of the previous decision, observe annual net cash flows from sales. If market research is the decision, evaluate the results of the test market (good news - a high probability of high sales, or bad news - a high probability of low sales)

● Step 5. Observe the annual cash flows after the market research.

Required:

1. Prepare decision trees for the new product development process.

2. Evaluate this new product prospect as a net present value project.

3. Evaluate this new product prospect as a real option.

4. What is the value of the option of waiting for market research before commercialisation?

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New product development data (dollar amounts in $million) R D investment cost no 180 00 million RD phase Probability of R D success Product life 2 years 70 800 years Discount rate Cost of commercialisation year 3 or 4 Commercialise year 3: 14 700 00 million CF yr 4 11 CF yr 4 11 Additional mar et research cost, year 3 ar et research Commercialise year 4 Good ne s CF yr 5 12 CF yr 5 12 Bad ne s CF yr 5 12 CF yr 5 12 620 00 40 100 00 60 50 00 million 50 620 00 60 100 00 40 50 620 00 40 100 00 60