W99NOONQ3.2
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 $5 million. If A-Team
fever strikes, you will sell action figures worth $10 million (in
present value). If the foolish youth of today do not catch the
fever, you will only sell action figures worth $2 million. 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 $1 million.
If I don’t do the survey, the expected NPV for the project is:
-$5million+(.5)($10million)+(.5)($2million) = $1 million
If I do the survey and the demand turns out to be low, I won’t produce the figures, so I won’t lose $3 million on pointless production. I’ll only produce the figures if demand is high. The expected NPV for the project is:
-1 million (for the survey) + (.5)(-$5million+$10million)+(.5)(0)=$1.5 million
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 $3 million, I stop. My losses are limited to the $1 million spent on the survey. I have put a floor on my losses.