Osceola Electronics, Inc., has developed a new HD DVD. If the HD DVD is successf

Question

Osceola Electronics, Inc., has developed a new HD DVD. If the HD DVD is successful, the present value of the payoff (at the time the product is brought to market) is $33.1 million. If the HD DVD fails, the present value of the payoff is $6.9 million. If the product goes directly to market, there is a 60 percent chance of success. Alternatively, Osceola can delay the launch by one year and spend $1.20 million to test-market the HD DVD. Test-marketing would allow the firm to improve the product and increase the probability of success to 80%. The appropriate discount rate is 10%.

What is the value of the option to test-market before going to market? (Round answer to 2 decimal places. Do not round intermediate calculations)

Explanation / Answer

We need to calculate the NPV of the two options:

Go directly to market now, or utilize test marketing first.The NPV of going directly to market now is:

NPV = (CSuccess * (Prob. of Success) + CFailure * (Prob. of Failure))

NPV = $33,100,000 * (0.60) + $6,900,000 * (0.40)

NPV = $22,620,000

Now we can calculate the NPV of test marketing first.

Test marketing requires a $1.20 million cash outlay.

Choosing the test marketing option will also delay the launch of the product by one year.

Thus, the expected payoff is delayed by one year and must be discounted back to Year 0.

NPV = C0+ (CSuccess * (Prob. of Success) + CFailure * (Prob. of Failure)) / (1 +R)t

NPV = –$1,200,000 + (33,100,000 * (0.80) + $6,900,000 * (0.20)) / 1.10

NPV = - 1,200,000 + 25,327, 272.73

NPV = 24,172,272.73

The company should test market first since that option has the highest expected payoff

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