Tandem Bicycles is noticing a decline in sales due to increased competition from

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.

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