1 Piraeus Technology is a small technology development partnership located outside Athens. The partners of Piraeus are planning the launch of a new tablet computer, the SQ, using a revolutionary processing system. The market for tablet computers is very competitive and the anticipated product life of the SQ is only 3 years. The marketing partner of Piraeus has produced the following data showing three different estimates of likely demand for the SQ during each year of its life.
Demand Year 1 Year 2 Year 3
Predictions Probability Units Units Units
Most optimistic 0.2 32 000 16 000 12 000
Best guess 0.5 16 000 8 000 6 000
Most pessimistic 0.3 4 000 2 000 1 500
The above estimates assume a constant selling price of €500 over the 3 years. The variable production cost per unit of an SQ is €400.
The partner in charge of production has stated that their small manufacturing facility is in a position to produce 32 000, 16 000 or 4 000 units per annum, but, once decided, the chosen production level could not be increased until the start of the following year. The total cost of setting up the production line would consist of fixed costs of €1 million, and variable costs of €50 for each unit of production capacity. These costs would be paid at the start of the year’s production.
A market research firm has offered, for a fee of €300 000, to carry out a detailed survey which would deter- mine precisely the future level of demand for the SQ. The partners of Piraeus Technology wish to know whether the market survey is likely to be worthwhile.
In order to assess whether the survey is worth undertaking the following simplifying assumptions are made:
(i) cash flows relating both to sales and variable production costs are to be deemed to arise at the end of the year in which they are incurred
(ii) demand can be represented by only one of the three sets of probabilities envisaged by the marketing partner (iii) the level of the demand in the first year will determine the levels demanded in the second and third years (iv) the appropriate discount rate for the venture is 10% per annum.
(a) Determine the initial production capacity that Piraeus Technology should choose, and compute the resulting ENPV of producing and selling at that level. (15 points)
(b) Calculate whether the market survey should be commissioned, and comment on any reservations you might have relating to the use of expected values as an aid in decision-making. (15 points)