W998AMQ3.2
2.You are considering making a Howlin’ Mad Murdock action figure to capitalize on what you are sure will be a massive resurgence in A-Team fever. Production will cost $1 million. If A-Team fever strikes, you will sell action figures worth $3 million (in present value). If the foolish youth of today do not catch the fever, you won’t sell any action figures (present value of $0). Each scenario has a 50% chance of happening. Before beginning production, you can field a marketing survey to determine which scenario will happen. The survey costs $200,000.
If I don’t do the survey, the expected NPV for the project is:
-$1million+(.5)($3million)+(.5)(0) = $500,000
If I do the survey and the demand turns out to be low, I won’t produce the figures, so I won’t lose $1million on pointless production. I’ll only produce the figures if demand is high. The expected NPV for the project is:
-.2million + (.5)(-$1million+$3million)+(.5)(0)=$800,000
In order to show that it is worth it to field the survey, you have to compare the two scenarios with and without the survey and show that you are better off with it than without. It not enough to simply do the survey scenario and show that it is a positive NPV project. It could still be a higher NPV without the survey. (Note that a project with an NPV of $1 million still has a positive NPV if I throw $100,000 out a 3rd story window and watch people fight for the cash, but that doesn't mean I'm better off throwing money out the window. )
The survey gives me an abandonment option. If demand is low, I can walk away without producing. Rather than producing and losing $1 million, I stop. My losses are limited to the $200,000 spent on the survey. I have put a floor on my losses.