Question

As a marketing manager for one of the world's largest automakers, you are responsible for the advertising campaign for a new energy- efficient sports utility vehicle. Your support team has prepared the following table, which summarizes the (year-end) profitability, estimated number of vehicles sold, and average estimated selling price for alternative levels of advertising. The accounting department projects that the best alternative use for the funds used in the advertising campaign is an investment returning 9 percent. In light of the staggering cost of advertising (which accounts for the lower projected profits in years 1 and 2 for the high and moderate advertising intensities), the team leader recommends a low advertising intensity in order to maximize the value of the firm. Do you agree? Explain. Profitability by Advertising Intensity Profits (in millions) Year 1 Year 2 Year 3 Units Sold (in thousands) Year 1 Year 2 Year 3 Average Selling Price Year 1 Year 2 Year 3 10 Advertising Intensity High Moderate Low $20 $40 $75 $ 80 $ 80 $110 $300 $135 $118 5 60 12.5 6 120 25 7.2 $35,000 $36,500 $38,000 $35,800 $36,100 $36,300 $35,900 $36,250 $36,000 4

Answer 1

Solution:-

Given that

The marketing team has projected profits from the sale of new model for the next 3 years with 3 levels of advertising intensity. Take out the present value of the projected value of the projected future profits from each of the advertising intensity - high, moderate and low, and choose the intensity which maximizes the value of firm.

Take out the present value of the projected future profits with High intensity advertising:

$PV_{HI}=\frac{FV_1}{(1+i)^1}+\frac{FV_2}{(1+i)^2}+\frac{FV_3}{(1+i)^3}$

where

$PV_{HI}$ = Present Value of the future profits with high intensity advertising.

FV1 = Profits at the end of the 1st year

FV2 = Profits at the end of the 2 nd year

FV3 = Profits at the end of the 3rd year

i = The interest rate or the opportunity cost of using funds

In this case,

FV1 = $ 20 million, FV2 = $ 80 million, FV3 = $ 300 million, i = 9 percent.

Substitute the numbers in the equation

$PV_{HI}=\frac{FV_1}{(1+i)^1}+\frac{FV_2}{(1+i)^2}+\frac{FV_3}{(1+i)^3}$

$PV_{HI}=\frac{20}{(1+0.09)^1}+\frac{80}{(1+0.09)^2}+\frac{300}{(1+0.09)^3}$

$PV_{HI}=\frac{20}{(1.09)^1}+\frac{80}{(1.09)^2}+\frac{300}{(1.09)^3}$

$PV_{HI}=18.35+\frac{80}{1.18}+\frac{300}{1.29}$

PVHI = 18.35 + 67.79 + 232.56

$PV_{HI}=318.70$

Thus, the present value of the future profits with high intensity advertising is $ 318.70 million.

Next, take out the present value of the projected future profits with Moderate intensity advertising:

In this case,

FV1 = $ 40 million

FV2 = $ 80 million

FV3 = $ 135 million, i = 9 percent

Substitute the numbers in the equation

$PV_{MI}=\frac{FV_1}{(1+i)^1}+\frac{FV_2}{(1+i)^2}+\frac{FV_3}{(1+i)^3}$

$PV_{MI}=\frac{40}{(1.09)^1}+\frac{80}{(1.09)^2}+\frac{135}{(1.09)^3}$

$PV_{MI}=36.7+\frac{80}{1.18}+\frac{135}{1.29}$

$PV_{MI}=36.7+67.79+104.65$

$PV_{MI}=209.14$

Thus, the present value of the future profits with moderate intensity advertising is $ 337.04 million. Next, take out the present value of the projected future profits with Low intensity advertising:

In this case,  

FV1 = $ 75 million

FV2 = $ 110 million

FV3 = $ 118 million

i = 9 percent

$PV_{LI}=\frac{FV_1}{(1+i)^1}+\frac{FV_2}{(1+i)^2}+\frac{FV_3}{(1+i)^3}$

$PV_{LI}=\frac{75}{(1.09)^1}+\frac{110}{(1.09)^2}+\frac{118}{(1.09)^3}$

$PV_{LI}=68.81+\frac{110}{1.18}+\frac{118}{1.29}$

$PV_{LI}=68.81+93.22+91.47$

$PV_{LI}=253.5$

Thus, the present value of the future profits with low intensity advertising is $ 253.5 million.

The present value of the future profits with high intensity advertising is $ 361.37 million and the present value of the future profits with low intensity advertising is $ 253.5 million.

Thus, its the high intensity advertising which will maximize the value of the firm in the long term. With high intensity advertising, the value of the firm will be $ 107.87 million higher compared to the low intensity advertising.

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