Maximizing Profit: Direct Market or Test Marketing?

Which option will maximize profit for Ang Electronics, Inc.?

If the DVDR is successful, the present value of the payoff when the product is brought to market is $34.8 million. If the DVDR fails, the present value of the payoff is $12.8 million. If the product goes directly to market, there is a 40 percent chance of success. Alternatively, the company can delay the launch by one year and spend $1.38 million to test market the DVDR. Test marketing would allow the firm to improve the product and increase the probability of success to 70 percent. The appropriate discount rate is 12 percent.

Profit Maximization Solution

The NPV of going directly to market is $21,600,000.

The NPV of test marketing before going to market is $26,408,571.

Explanation

In order to calculate the NPV of going directly to market, we first need to determine the Expected Present Value of Payoff:

Expected Present Value of Payoff = $34,800,000 * 40% + $12,800,000 * (1-40%)

Expected Present Value of Payoff = $21,600,000

Therefore, the NPV of going directly to market is $21,600,000.

To calculate the NPV of test marketing before going to the market, we need to use the following calculation:

NPV = -Initial cost in Testing + PV of Expected Present Value of Payoff in one year

NPV = -$1,380,000 + ($34,800,000 * 70% + $12,800,000 * (1-70%)) / (1+12%)

NPV = $26,408,571

Therefore, the NPV of test marketing before going to market is $26,408,571.