Question

Your company has just completed a $0.85 million marketing survey that found that your new product is going to be a big hit. Producing the game will require an immediate (year 0) $0.9 million capital investment. Net working capital will have to increase in year 0 from $0.5 million to $1million, and will return to the original 0.5 million level at the end of the project. You expect annual revenues of $5 million in years 1 through 3. The variable and fixed costs will equal 70% of annual sales. You also project that 25% of those revenues will come from your existing customers switching from your old game, which also has costs equal to 70% of sales. The new equipment will be depreciated over 3 years to a book value of 0 using the straight-line method. You have contracted to sell the equipment for $0.4 million at the end of the third (3rd) year, at which point production will end. Your discount rate is 12% and your tax rate is 25%.

Show the relevant cash flows for this project in years 0 through 3 and compute its NPV. Should you produce new game? Why yes or why not?

(Free) Cash Flow from Assets : Year 0 Year 1 Year 2 Year 3

NPV=

Answer 1

We should not consider $0.85 million in the cashflows because these are sunk costs which are unavoidable though you dont accept the project.

We should consider the cannibalization effect on the cashflows. I have reduced the eaten away cashflows of the company because of this project

For example, Year1 cannibalization cost=(25%*revenues)-(75%*25%*revenues)

=(25%*5000000)-(75%*25%*5000000)

=375,000

NPV(rate, Year1 to Year 3 cashflows)-Total cost

NPV(12%, Year1 to Year3 cashflows)-1400000

NPV=$1,376,106.68