Question

1. Dickens and Victoria (DAV) plans to market a new line of stuffed animals, which it will sell for five years. The stuffed animals would cost $7 each to manufacture, and would sell for $15 each. Initial setup costs would be $5,000,000. There is a 60% chance demand would be 300,000 units per year, and a 40% chance demand would be 100,000 per year. DAV has a 10% required rate of return. DAV will run a focus group just before beginning sales that will allow them to learn whether demand will be high or low.

In solving this problem, use Excel functions for present value or mathematical formulas for present value rather than using present value factors from tables.

a. What is the expected net present value of the project?

b. Suppose that after running the focus group, DAV could choose to add a voice-box to the stuffed animals to make them more realistic. The feature would raise demand to 500,000 per year, but it would cost an additional $1.50 per unit plus an additional $1,400,000 fixed cost per year for equipment to insert the voice-boxes. What is the value of the project using real options analysis?

c.    Given the information in part b, what is the value of the real options associated with the project?

Answer 1