A new product has two major potential markets. The product will succeed in both
ID: 2775261 • Letter: A
Question
A new product has two major potential markets. The product will succeed in both or fail in both, with equal probability. The markets are otherwise independent. You may enter the markets sequentially or simultaneously either now, one year from now, or two years from now. Later entry is not feasible. Market A requires an initial investment of $100 regardless of when it is entered. If the product is successful, market A will have a present value of $150 one year after entry. If the product fails Market A will be worth $90 one year after entry. Market B requires an initial investment of $55 regardless of when it is entered. One year after entry, B will have a present value of $130 or $20 for success and failure, respectively. For simplicity, perform all discounting in the problem at 5%.
What are all the possible combinations of time and place for introducing the new product? Can any possibilities be eliminated as suboptimal without further calculations? Why or why not? Which strategy is optimal?
Explanation / Answer
We have three strategies for these investments.
Strategy one: Enter in the market now
Strategy 2: Enter in the market after one year
Strategy 3: Enter in the market after two years
Possible combinations can be:
Strategy one: Project A only, Project B only, Both project A and B
Strategy two: Project A only, Project B only, Both project A and B
Strategy three: Project A only, Project B only, Both project A and B
Calculation of NPV
Project A
Expected PV one year after the project introduced = 0.50x 150 +0.50x90
= 120
NPV = Expected PV one year after the project introduced/(1+r) - Investment
=120/(1+0.05)-100
=14.29
Project B
Expected PV one year after the project introduced = 0.50x 130 +0.50x200
= 75
NPV = Expected PV one year after the project introduced/(1+r) - Investment
=75/(1+0.05)-55
=16.43
Choosing project A only is suboptimal as it has lower NPV and higher investment as compared to project B.
Choosing Both project A and project B in year 0 is the optimal strategy as it has the highest amount of NPV.
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