Question 18.9: MedEQuipt New Product Development Tree MedEQuipt has identif...
MedEQuipt New Product Development Tree
MedEQuipt has identified a need for a new blood analysis test unit. However, it will be used only in some infertility clinics, so the potential market is relatively small. The first decision between alternatives is whether to (1) forgo the project, (2) begin normal development, or (3) accelerate development. If MedEQuipt forgoes the project, no costs or profits result. Normal development will take a year, cost $450,000, and almost certainly lead to a successful project. Thus, there is a 95% chance of meeting a market need that should produce profits of $100,000 per year for 10 years. These revenues begin in the second year, and they are assumed to occur at the end of each year.
The accelerated program skips some steps, so it only costs $250,000. Since it is done earlier, there are operating profits of $50,000 for the first year. Since a larger market share is established, the profits for the 10 years beginning in year 2 are larger, $125,000 per year. Unfortunately, the accelerated program has a 40% chance of failure. Assume the costs occur at time 0 and that the actions of MedEQuipt’s competitors will close the market niche if the development alternative is unsuccessful. Describe this problem using a decision tree.
The decision has three alternatives. Forgoing development has a sure outcome of $0; each of the other two has costs and leads to a single chance node. While the chance branches represent success or failure, the probabilities and consequences following normal and accelerated development differ. The decision tree in Exhibit 18.5 has three branches from the first decision node 1 (one no-go and two go), and each of the two go branches have chance nodes (nodes 2 and 3) with two branches apiece.
Notice that years are included for each cash flow, since the value of the cash flows depends on when they occur (if they occur at all). Notice also that the probabilities from a chance node must sum to 1 (see the axioms in Section 18.1).
