Consumer Products, Inc. (CPI) can pay one of its foreign suppliers $20 million to obtain exclusive marketing rights to a new product. Demand for this product is uncertain, but CPI's preliminary estimates indicate that there is a 50% chance of strong product demand, which will result in cash inflows of $5.2 million per year for 8 years; there is a 20% chance of moderate product demand, which will result in cash inflows of $4.5 million per year for 8 years; and there is a 30% chance of weak demand, which will result in cash inflows of $4.0 million per year for 8 years. For $2 million, CPI can conduct a feasibility study that will confirm whether product demand will be strong, moderate, or weak, and then CPI can decide whether to purchase rights to the product. CPI’s cost of capital applicable to the proposed new product decision is 12%.
a. Draw the decision tree associated with CPI’s proposed feasibility study.
b. Calculate the NPV associated with each of the possible product demand outcomes—strong, moderate, and weak.
c. Find the expected NPV of performing the feasibility study.
d. Based on your findings in part (c), what recommendation would you give CPI about the proposed feasibility study? Explain.