Question

ABC Ltd. considers investing in a research project that produces two types of products: X and Y. Product X is more innovative and will be produced only if the research is successful. If the research is not successful, the firm can modify the research outcome and will produce Product Y, which is less innovative. The research is expected to take 3 years to complete. The firm can only tell if the development is a success or failure at the completion of the development. There is only a 20% chance that the research is successful and Product X will be produced. The research costs $2.85 million today.

If successful, Product X will be highly sought after and will earn the firm a net after-tax operating cash flow of $800,000 per annum over the following two years (i.e. year 4 and year 5). At the end of year 5, the firm will have an option to abandon the production depending on the demand for Product X. Management team believes that there is a 60% probability that demand for Product X will be high and the net after-tax operating cash flow will be $800,000 per annum in perpetuity starting from year 6. However, if the demand is low by the end of year 5, the firm will abandon the production and it will be able to salvage $100,000 by selling the production in year 5.

If the development fails, Product Y will be produced and will earn the firm a net after-tax operating cash flow of $400,000 per year for the next two years. At the end of year 5, the firm will have an option to spend $300,000 to upgrade the production plant. If the demand for Product Y is high in year 5 (with 40% probability), the firm will certainly upgrade Product Y and the net after-tax operating cash flow will be $800,000 each year in perpetuity starting from year 6. However, if the demand for Product Y is low in year 5, the firm will not upgrade the production and the net after-tax operating cash flow will be $400,000 each year in perpetuity starting in year 6. The company’s cost of capital is 10 percent.

Required: What is the net present value of this project? Should the firm undertake this project and Why?

Answer 1

Solution:

Decision to make Product X
Year	Cash Flows	PV - (formulae- 1/(1+r%)^n	PV of Cash flow
1	0	0.909091	0
2	0	0.826446	0
3	0	0.751315	0
4	800000	0.683013	546410.8
5	800000	0.620921	496737.1
6	800000	0.564474	451579.1
7	800000	0.513158	410526.5
8	800000	0.466507	373205.9
9	800000	0.424098	339278.1
10	800000	0.385543	308434.6
11	800000	0.350494	280395.1
12	800000	0.318631	254904.7
13	800000	0.289664	231731.5
14	800000	0.263331	210665
15	800000	0.239392	191513.6
		Total of PV	4095382
		Cost of Research	2850000
		NPV	1245382

NPV is postive after 15 years uptill that NPV is negative

When Product Y is produced and the plant is upgraded the NPV will be as follows:

Product Y
Year	Cash Flows	PV - (formulae- 1/(1+r%)^n	PV of Cash flow
1	0	0.909091	0
2	0	0.826446	0
3	0	0.751315	0
4	400000	0.683013	273205.4
5	400000	0.620921	248368.5
6	800000	0.564474	451579.1
7	800000	0.513158	410526.5
8	800000	0.466507	373205.9
9	800000	0.424098	339278.1
10	800000	0.385543	308434.6
11	800000	0.350494	280395.1
12	800000	0.318631	254904.7
13	800000	0.289664	231731.5
14	800000	0.263331	210665
15	800000	0.239392	191513.6
		Total of PV	3573808
		less: Cash Outflow	3500000
		NPV	73808.1

When Product Y is produced and there is no upgration of the plant and cash flows of 400000 are generated till perpetuity.

Year	Cash Flows	PV - (formulae- 1/(1+r%)^n	PV of Cash flow
1	0	0.909091	0
2	0	0.826446	0
3	0	0.751315	0
4	400000	0.683013	273205.4
5	400000	0.620921	248368.5
6	400000	0.564474	225789.6
7	400000	0.513158	205263.2
8	400000	0.466507	186603
9	400000	0.424098	169639
10	400000	0.385543	154217.3
11	400000	0.350494	140197.6
12	400000	0.318631	127452.3
13	400000	0.289664	115865.8
14	400000	0.263331	105332.5
15	400000	0.239392	95756.82
		Total of PV	2047691
		less: Cash Outflow	3500000
		NPV	-1452309

Case 1: NPV when Product X is produced = 1245382

Case 2 N.P.V when  Product Y is produced and the plant is upgraded= 73808.1

Case 3 N.P.V when Product Y is produced and the plant is not upgraded and cash flows of 400000 are generated till perpetuity.= (1452309)

Decision Rule: Accept the project when N.P.V is positive