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CMA Foundation · Fundamentals of Business Economics and Management · Decision-making - Types and Process

A decision tree for Mehta Foods has a chance node with two outcomes: a launch succeeds with probability 0.6 giving Rs 10,00,000, or fails with probability 0.4 giving Rs -2,00,000. Launching costs Rs 3,00,000 upfront. Not launching gives Rs 0. What is the net expected value of launching, and what should be decided?

The net expected value of launching is Rs 2,20,000, so the firm should launch. The chance node gives 6,00,000 minus 80,000, which is 5,20,000; subtracting the Rs 3,00,000 launch cost leaves a positive Rs 2,20,000, better than the zero from not launching.

  1. ARs 5,20,000 net; launch
  2. BRs 2,20,000 net; launchCorrect
  3. CRs 2,20,000 net; do not launch
  4. DRs 5,20,000 net; do not launch

Explanation

Expected value at the chance node = 0.6 x 10,00,000 + 0.4 x (-2,00,000) = 6,00,000 - 80,000 = 5,20,000. Deduct the launch cost of 3,00,000 to get 2,20,000 net, which exceeds 0, so launch. Ignoring the cost gives 5,20,000, the key mistake.

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