CMA Intermediate · Management Accounting · Decision Theory
Rohit Pharma may spend Rs 4 lakh on a pilot test. The test succeeds with probability 0.5. If it succeeds, full launch gives an expected net payoff of Rs 30 lakh (before the pilot cost); if it fails, the firm stops and gets nothing further. Without the pilot, the firm can launch directly: a 0.5 chance of Rs 30 lakh and 0.5 chance of a Rs 12 lakh loss. Which strategy has the higher EMV, and what is it?
The pilot test is better, with an EMV of Rs 11 lakh (0.5 x 30 less Rs 4 lakh cost) versus Rs 9 lakh for direct launch (15 less 6). The pilot avoids the loss in the failure case.
- APilot test, EMV Rs 11 lakhCorrect
- BPilot test, EMV Rs 15 lakh
- CDirect launch, EMV Rs 9 lakh
- DDirect launch, EMV Rs 18 lakh
Explanation
Pilot: 0.5 x 30 + 0.5 x 0 - 4 = 11 lakh. Direct: 0.5 x 30 - 0.5 x 12 = 15 - 6 = 9 lakh. Pilot is higher at Rs 11 lakh. Rs 15 lakh forgets the pilot cost.
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