Question

Suppose that a person is considering an investment in a new product. The cost of producing and marketing the product is estimated to be $6 000. Three possible outcomes can result from this investment:

• The product can be extremely successful and yield a net profit of $24,000.
• The product can be moderately successful and yield a net profit of $12,000.
• The product can be unsuccessful, in which case the loss will be equal to the initial cost of producing and marketing the product (that is, $6,000).

Additionally, assume that if the person does not invest in the new product, the $6,000 can be invested in another venture that is certain to yield a net profit of $1,500. Furthermore, suppose that he or she has assessed the chances of the product being extremely successful, moderately successful, and unsuccessful at .10, .20, and .70, respectively.

You are required to do the following:

1. Determine the decision alternatives.
2. Determine the possible outcomes for each decision alternative.
3. Formulate the problem in a payoff table format showing the net profit that will result from each alternative action/state-of-nature combination.
4. Determine the expected net profit of each decision alternative.
5. Assuming that the objective is to maximise expected monetary payoff, which alternative should be chosen?

Answer 1

A.

There are two decision alternatives.

The first alternative is invest in new product.

The second alternative is to invest in another venture to get assured return.

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B.

Possible outcome for the alternative to invest in new product:

1. Earn net profit of $24000 when extremely successful

2. Earn net profit of $12000 when moderately successful

3. Earn loss of $6000 when unsuccessful.

Possible outcome for the alternative to invest in another venture:

Net profit of $1500 with certainty.

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C.

	Net profit Table
Decision alternatives	Extreme successful	Moderate successful	Unsuccessful
Invest in new product	$24000	$12000	-$6000
Invest in another venture	$1500
	0.1	0.2	0.7

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D.

Net profit for invest in new product alternative = 24000*.1 + 12000*.2 - 6000*.7

Net profit for invest in new product alternative = $600

Net profit for invest in another venture alternative = $1500

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E.

Alternative of invest in another venture will be selected, because it maximizes net profit that is $1500.