: A Venture Capital firm has an option with respect to a new product (codenamed LMD-X) developed by one of its research ventures. It has to decide whether to proceed with test marketing LMD-X or whether to abandon the project/product. The estimated cost of the test marketing is $120,000. Past experience indicates that only 30% of products are successful in test market. If LMD-X is successful at the test market stage then the company faces a further decision relating to produce or not, and if they do, the production scale to set up for production.

A small plant will cost $150,000 to build and produce 2,500 units a year, while a large plant will cost an extra $250,000 to build but produce 3,500 units a year. Or they could still choose to walk away if the product does not appear to be profitable. One key to profitability will be the presence of a competitor product. The marketing department have estimated that there is a 40% chance that a competitor will respond with a similar product and that the profit per unit sold (in $) will be as follows (assume all units produced are sold):

Large plantSmall plant

Competitor respond$32$28

Competitor does not respond$45$42

The estimated market life for LMD-X is assumed to be approximately 7 years and that the yearly plant running costs are $35,000 for a small plant and $55,000 for a large plant. Altogether, this results in the following overall net profits (not including the decision/cost of the test marketing) of

Plant Size Competitor Overall Net Profit

(not including test market cost)

Small plant

No

$340,000

Large plant

No

$467,500

Small plant

Yes

$95,000

Large plant

Yes

$149,000

a) For the above scenario, set up and solve the associated decision tree to portray the decision strategy with the highest expected net profit. Below the tree, state the decision strategy determined and the expected net profit.

b) Calculate the EVPI for additional informational on whether the test marketing would be successful or not.