Answer to Question #280829 in Finance for SIMON

Question

A firm spent $10 million to develop a product for market. In the product’s first two years, its profit was $6 million. Recently, there has been an influx of comparable products offered by competitors (imitators in the firm’s view). Now the firm is reassessing the product. If it drops the product, it can recover $2 million of its original investment by selling its production facility. If it continues to produce the product, its estimated revenues for successive two-year periods will be $5 million and $3 million and its costs will be $4 million and $2.5 million. (After four years, the profit potential of the product will be exhausted, and the plant will have zero resale value.) What is the firm’s best course of action?

Answer 1

For the first two years profit is $\$6million$

If it drops the product ,they would recover $\$2 million$ therefore total money accrued would be; $\$6million+\$2million=\$8million$

If it continues to produce the product, the profit in the subsequent two years would be;

profit=revenue -costs

$=(\$5+\$3)-(\$4+\$2.5)million$

$=\$1.5million$

Therefore total money accrued would be; $\$6million+\$1.5 million=\$7.5 million$

The firms best course of action would be to drop the product since they would make $\$8million$ as compared to continue producing the product where they would make $\$7.5 million$