Question
Compute the expected net profit of the new product without market forecast: ENPN = P(S)(10) + P(N)(-5) Compare it with the net profit of the
Compute the expected net profit of the new product without market forecast:
ENPN = P(S)(10) + P(N)(-5)
Compare it with the net profit of the existing product, ENPE
Expected value without information (market forecast) = EVw/oI = max (ENPN, ENPE)
A major use of decision tree analysis is to estimate the expected value of information. We will use the following simple example to illustrate the application process.
In this case, a CEO needs to decide whether to invest $5 million to improve an existing product, which is sure to yield a profit of $7 million, or to develop a new product, which will yield a profit of $15 million if successful or $0 if not successful. A consultant offers to conduct a market forecast for the new product for a fee of $0.5 million. Should the CEO hire the consultant and in which product should the CEO invest?
A 2-stage tree shown below describes the decision process: the first stage is to decide whether to acquire the information; the second stage is to decide which product to invest. For simplicity, we assume that the CEO is risk-neutral and wants to maximize the expected net profit.
Stage 1 No consultant Hire consultant, $0.5 million P (F) Favorable Prediction Unfavorable Prediction P(U) Stage 2 New, $5 million Existing, $5 million New, $5 million Existing, $5 million New, $5 million P(S) P(N) P (SF) P(NF) Profit Success $15 million $10 million No No SO No $7 million P (NU) Success $15 million $10 million SO P (SU) Success $15 million SO Net Profit $7 million -$ 5 million $ 2 million -$ 5 million $ 2 million $10 million -$5 million
Step by Step Solution
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