Solution Activity 1

The sales units on each path are multiplied by the contribution per unit to give the total contribution. This is then multiplied by the probability of occurrence to give the pay-off. The pay-off on the first pathway is 16,000x0.7x0.5 = 5,600. All paths are summed to give an expected value of 6,100 if the product is launched and, obviously, if the product is not launched the return is zero. So in the absence of other considerations the decision-maker would decide to launch the new product. Activity 2

The situation is shown in the form of a decision tree above . For purposes of clarity the two decision points are labelled A and B. Although in practice decision A precedes decision B, for the purposes of calculation decision B has to be decided first. Decision B The expected cash flow on the first path is 800,000 - 150,000 - 650,000. This is then multiplied by the probability of occurrence once the decision to market has been made, that is, by 0.6 to give 390,000. The second path shows that there is a 40% chance of making a loss of 250,000 [100,000 - 150,000]. The expected value of marketing is therefore 290,000 compared with an expected value of only 30,000 from selling the designs and product [ 180,000 _ 150,000]. Therefore, it will pay to market the product if development goes ahead. The Sell option can now be eliminated from our analysis. Decision A The expected value of marketing and of failure are summed and compared with the 100,000 if the designs are sold. The 390,000 on the first path is multiplied by the probability of success, 0.7, etc. as shown under the Pay-off column. The expected value is 164,000. This is greater than 100,000 and so the product should be developed and marketed.