Valuing a New Product at EToys*

EToys.com, an up-and-coming creator of electronic toys, was in the midst of planning the introduction of a new product. The initial marketing plan was based on the expected profitability of the product over the next four years. However, several participants in the debate recognized that the results might be sensitive to the assumptions on which they were based, and requested an analysis that took uncertainty into account.

The initial estimates were that the company could sell 75,000 units the first year with an increase of 12% per year thereafter. The selling price would be $19.95 the first year with an annual increase of $2.00. Variable costs per unit were broken down into four categories as follows:

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Raw Materials $4.50

Direct Labor $7.50

Packaging $1.25

Distribution $0.75

Inflation was expected to be 4% in each of the next two years, rising to 6% in the fourth year. Fixed costs for the product were $25,000 for the factory and $15,000 for other fixed costs, and these were expected to remain constant over the next four years. Finally, the effective tax rate was assumed to be 22%.

In subsequent discussions, the management team agreed that three assumptions made in the analysis were especially uncertain. These were the initial sales price, unit sales, and labor costs. Careful consideration of these uncertainties would be necessary before coming to a decision. But not today….

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