Question

ABC Company is preparing to launch a new product. They are considering three different product designs and will select only the one product that yields the highest revenue. A feasibility study suggest that product development, regardless of which of the three products is selected, will cost $1,250,000 initially, which includes all design, testing, set-up and initial operating costs. Annual operating cost, once the selected product is placed into production, will cost $125,000 and the net revenue for the first year is projected to be $450,000. Both the project costs and revenues are independent of the option selected. Market analysis for each of the three products suggest that subsequent revenues, i.e. the revenues received at the end of each year starting in year 2, will differ as described below

•  Design 1: The revenue will increases by $75,000 per year.

•  Design 2: Revenues will remain the same for the next two years (i.e. years 2 and

  3) and then will increase by 10% each year, over the previous year, in each

  subsequent year.

•  Design 3: Revenues will increase in years 2 through 4 by 10% per year, then in

  years five through seven, revenues will be $300,000, $225,000, and 150,000 per year, respectively.

• If the product’s life is 7 years and the market interest rate is 8% per year, which of the threeproduct designs should ABC Company launch? To answer this question compare the future values of the cash flows for each of the three designs over the first seven years.

Answer 1

Future value of cash value for design 1

Year	Investment	Revenue Design 1	Annual cost	Net cash flow	FV Factor	Future value
0	-1250000			-1250000	1.71382427	-21,42,280.34
1		450000	-125000	325000	1.58687432	5,15,734.15
2		525000	-125000	400000	1.46932808	5,87,731.23
3		600000	-125000	475000	1.36048896	6,46,232.26
4		675000	-125000	550000	1.259712	6,92,841.60
5		750000	-125000	625000	1.1664	7,29,000.00
6		825000	-125000	700000	1.08	7,56,000.00
7		900000	-125000	775000	1	7,75,000.00
Future Value for design 1						25,60,258.91

Future value of design 2

Year	Investment	Revenue Design 2	Annual cost	Net cash flow	FV Factor	Future value
0	-1250000			-1250000	1.71382427	-21,42,280.34
1		450000	-125000	325000	1.58687432	5,15,734.15
2		450000	-125000	325000	1.46932808	4,77,531.62
3		450000	-125000	325000	1.36048896	4,42,158.91
4		495000	-125000	370000	1.259712	4,66,093.44
5		544500	-125000	419500	1.1664	4,89,304.80
6		598950	-125000	473950	1.08	5,11,866.00
7		658845	-125000	533845	1	5,33,845.00
Future Value for design 2						12,94,253.60

Future value of design 3

Year	Investment	Revenue Design 3	Annual cost	Net cash flow	FV Factor	Future value
0	-1250000			-1250000	1.713824	-21,42,280.34
1		450000	-125000	325000	1.586874	5,15,734.15
2		495000	-125000	370000	1.469328	5,43,651.39
3		544500	-125000	419500	1.360489	5,70,725.12
4		598950	-125000	473950	1.259712	5,97,040.50
5		300000	-125000	175000	1.1664	2,04,120.00
6		225000	-125000	100000	1.08	1,08,000.00
7		150000	-125000	25000	1	25,000.00
Future Value for design 3						4,21,990.83

Since future value of design 1 is highest, so we will select design 1