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Sir, here’s a question :
Darwin uses decision tree analysis in order to evaluate potential projects. The company has been looking at the launch of a new product which it believes has a 70% profitability of success. The company is, however, considering undertaking an advertising campaign costing $50,000, which would increase the profitability of success to 95%.
If successful the product would generate income of $200,000 otherwise $70,000 would be received.
What is the maximum that the company would be prepared to pay for the advertising? (The answer is $32,500 but how?)
Without the advertising the expected profit is (0.70 x 200,000) + (0.3 x 70,000) = $161,000
With the advertising the expected profit is (0.95 x 200,000) + (0.05 x 70,000) = $193,500
Therefore the most they will pay for advertising is 193,500 – 161,000 = $32,500.
Have you watched my free lectures on this? The lectures are a complete free course for Paper PM and cover everything needed to be able to pass the exam well.
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Sir,may I know why we didn’t take into account the cost of $500000?
There is no mention of $500,000 in the question.
I assume that you are referring to the advertising cost of $50,000. It is not relevant because the question asks what is the maximum that they would be prepared to pay for the advertising. The most is is worth paying is $32,500 (and therefore it is not sensible for them to pay $50,000 – it is only worth undertaking the advertising campaign if the cost was less than $32,500).
Have you watched my free lectures on calculating the benefit of perfect knowledge?
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