Tandem Bicycles is noticing a decline in sales due to increased competition from
ID: 2794848 • Letter: T
Question
Tandem Bicycles is noticing a decline in sales due to increased competition from abroad. The CFO sees the following options to respond:
1. Lower price, resulting in a 1.3M decline in cash flows. If they lower price, there is a 55% chance they will lose no other cash flow to imports and a 45% chance that they will lose another $550,000 in cash flow to imports.
2. Hire a lobbyist to convince the government that there should be tariffs on imported bicycles. This will cost $800,000 and have a 75% chance of working. If it works there will be no cash flow loss to Tandem, but if it doesn’t, there will be $2M reduction in cash flow.
What would you recommend and why?
Explanation / Answer
We need to compute the expected total reduction cash flows under both the situations.
Option 1
Extra Decline in cash flow if they lower price and it works = $0
Extra Decline in cash flow if they lower price and it does not work = $550,000
Probability of working = 0.55, Probability of not working = 0.45
Expected decline in cash flows = (-)$1,300,000 + $0 x 0.55 + (-)$550,000 x 0.45 = (-)$1,547,500
Option 2
Extra Decline in cash flow if they hire lobbyist and it works = $0
Extra Decline in cash flow if they hire lobbyist and it does not work = $2,000,000
Probability of working = 0.75, Probability of not working = 0.25
Expected decline in cash flows = (-)$800,000 + $0 x 0.75 + (-)$2,000,000 x 0.25 = (-)$1,300,000
It is recommened to opt second option as its expected decline in cash flows is lower in comparison to the first option.