Question

Your firm is considering investing $30 million to develop a new product. It is expected that it will take 18 months to develop the product. If the firm decides to take the product to market it will cost $300 million and six months to build production and distribution facilities. The expected incremental after-tax inflows from this new product will be $10 million in year 1 of operations and is expected to grow by 3%/year in perpetuity. If the discount rate is 6%/year for the outflows and 12% for the inflows and if we assume the outflows occur at the beginning of the year but the inflows occur at the end of the year, should the firm invest the $30 million to develop the new product?

Answer 1

Present Value of Outflows:

development cost = $30 million. As the outflows occur at the beginning of the year, this is an outflow at the beginning (present time) and does not need to be discounted

Production/Distribution facility cost = $300 million / (1 + 6%)^1.5, which is $274,892,225 As the outflows occur at the beginning of the year, it can be assumed that the outflow of $300 million occurs at the beginning of the six-month period

PV of outflows = $30 million + $274,892,225 ==> $304,892,225

Present value of inflows:

The first cash inflow of $10 million occurs after 36 months (18 months development + 6 months building time + 12 months ). We add 12 months because the inflows occur at the end of the period

The value of the project after 36 months = cash inflow at end of year / perpetual growth rate

value of project after 36 months = ($10 million * 1.03) / (0.03) ==> $343,333,333

Present value of inflows = $343,333,333 / (1 + 12%)^3 ==> $244,377,885

Net present value = present value of inflows minus present value of outflows

NPV = $244,377,885 - $304,892,225 ==> -$60,514,340

As the NPV is negative, the firm should not invest the $30 million to develop the new product