Question

Ooba Electronics is considering whether to develop a new line of robots designed to train dogs. The first generation robots will be on the market for 3 years, after which Ooba could release an improved second-generation dog-training robot. Data for the both the first-generation and second-generation projects are summarized below.

1st Generation: Robots are expected to sell for $600 in years 1 through 3.

Sales volume is expected to be 3000, 6000 and 10000 in years 1 to 3 respectively.

Fixed costs will be $500,000 per year.

Variable costs will be $200 per robot.

Initial costs for production equipment and software design are estimated at $8 million (in year 0). These costs are can be depreciated using straight-line to zero over the next three years. The equipment will have no salvage value at the end of the three years.

Net working cash flow changes are negligible for this project.

The appropriate risk-adjusted discount rate is 24%. The risk-free rate is 6%. Both rates are simple annual rates. The tax rate is 34%.

2nd Generation: Robots are expected to sell for $400 in years 4 through 10.

Sales volume is expected to be 12000 per year in years 4 to 10 respectively. This is the expected cash flow, but the actual cash flow might be much higher or lower.

Fixed costs will be $500,000 per year.

Variable costs will be $160 per robot.

Additional costs for production equipment and software design are estimated to be $8 million (in year 3). These costs can again be depreciated using straight-line to zero over the next three years. The equipment will have no salvage value at the end of the project.

Net working cash flow changes are negligible for this project.

The appropriate risk-adjusted discount rate is 24%.The risk-free rate is 6%. Both rates are simple annual rates. The tax rate is 34%.

Since the sales volume of the 2nd generation project is volatile, the present value of the cash flows is also volatile. Assume that the PV of the operating cash flows of the 2nd generation project can be approximated by the binomial distribution. How high does the annual volatility have to be to make it worthwhile for Ooba do the 1st generation project?

Hint: For simplicity, use annual steps in your binomial tree. You will also want to use the Solver or the Goal Seek Function in Excel to answer the question.

Answer 1