Create a risk profile

The executives of Electronic Products Company (EPC) have to decide which of two products to introduce, A or B.  Each has been in the R&D process for about 4 years and the company feels that they are now ready for introduction.  Additionally, considerable market research has been done to assses the market for each product.  Each of these new products is expected to have a five year life before renewal or phase-out.

Product A is essentially a lower risk proposition.  For this product, market research has made estimates of likely market sizes and profitability as follows:  Sales may be high, with a resulting profit of $10 million, medium with a net profit of $5 million, or low, in which case the company just breaks even.  The probabilities for these outcomes are respectively, 0.50, 0.20, and 0.30.

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Product B is a little more risky in that the plant size has to be matched to the demand for the product.  There are two key decisions to be made which deal with plant size, namely, the initial size and the final size.  The possibilities for the initial and final size are either small or large as demand could be either low or high initially.  Follow-on demand could also be low or high but it is possible that demand changes so that a low initial demand could eventually become high and a high initial demand could eventually sharply drop to a low volume.  The initial plant size will be for the first two years, at which point a decision has to be made on whether to expand the plant if demand exceeds capacity.  The additional cost of a plant expansion is $1.0 million.  If a large plant is initially built, then there is no need to expand but it is difficult to downsize the plant.  If the plant is initially too small to meet demand, lost sales and unhappy customers will be the result but the plant can be expanded after two years to alleviate the situation.  However, if the plant has too much excess capacity, then profitability is greatly reduced and some losses become a possibility.  The probability of initial sales being low or high is 0.4 and 0.6 respectively.  The likelihood of follow-on sales being low or high is dependent somewhat on initial sales and is shown below along with the corresponding profitability.

Probability Analysis for Product B

Initial Sales        Follow-on Sales (Years 3-5)

(First 2 Years)       Low        High

Low                    0.60        0.40

High                   0.30        0.70


The Corporate Financial Analysis Division, working with Sales and Marketing, has come up with the following profitability estimates for Product B based on the possible scenarios.  The total profit for the 5-year planning period would be the profit made in the first two years plus that made in years 3-5. The estimated cost of the plant expansion ($1.0 million) is not included in these figures.

Profit Table ($ in Millions)

Years 1-2                                    Years 3-5

Low Demand     High Demand    Low Demand     High Demand

Small Plant               1.0                    1.5                      1.5                    2.0

Large Plant             -1.0                     5.0                      -2.0                  10.0


(a)     Which product should EPC introduce?  (show work/analysis)

(b)     Create a risk profile for EPC.

(c)     How risky is EPC’s best solution?

(d)    Suppose the CEO of EPC has reservations about your analysis of his key decision on new product introduction.  He wants to know if there is a way to account for his view of risk and how he would make some of the decisions other than just EMV.  Explain what you would have to do to satisfy his fears.

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