Management accounting

Prepour Limited is considering the launch of a new consumer equipment which will have a project horizon of three years. At the moment the company has two courses of action open to it either to test market the product or to abandon it.

If the company test markets the product, the cost will be GHS100,000 and the market response could be positive or negative with probabilities of 0.60 and 0.40.

If the response is positive the company could either market the product full scale or abandon it.

If the company markets the product full scale, the outcome might be high, medium or low demand, and the respective cash flows would be GHS1,000,000, GHS200,000 or (GHS200,000) for each of the next three years. These outcomes have probabilities of 0.30, 0.50 and 0.20 respectively.

If the result of the test marketing is negative and the company goes ahead and markets the product, estimated cash flows would be GHS10,000 per annum.

If, at any point, the company abandons the product, there would be a net cash flow of GHS50,000 from the sale of scrap at the end of year one.

The company uses 10% discount rate.

Assume that all cash inflows occur at the year-end.

Required

a) Draw a decision tree to represent the various courses of action open to the company.

b) Calculate the present value of cash flows for each possible decision/outcome combination.

c) Recommend a course of action to the company with reasons.