Question

FastTrack​ Bikes, Inc. is thinking of developing a new composite road bike. Development will take six years and the cost is $205,900 per year. Once in​ production, the bike is expected to make $298,599 per year for 10 years. The cash inflows begin at the end of year 7. For parts​ a-c, assume the cost of capital is 10.5%.

a. Calculate the NPV of this investment opportunity. Should the company make the​ investment?

b. Calculate the IRR and use it to determine the maximum deviation allowable in the cost of capital estimate to leave the decision unchanged.

c. How long must development last to change the​ decision?

For parts​ d-f, assume the cost of capital is 14.6%.

d. Calculate the NPV of this investment opportunity. Should the company make the​ investment?

e. How much must this cost of capital estimate deviate to change the​ decision?

f. How long must development last to change the​ decision?

Answer 1

a : NPV according to the NPV calculator or NPV formula on excel is $102,823.89 and as the NPV is positive, company should definitely make the investment.

b. IRR according to the IRR calculator or IRR formula on excel is 12.146%

We compare this to the cost of capital, 11.2%.

11.2-10.5 = 0.7% , since IRR is greater than cost of capital, company should make an investment.

Think of the IRR as the return on the investment, how much we're making on it. The cost of capital is like the interest rate on your credit card. The cost of getting that money. You want your IRR to be greater than the cost of capital, otherwise, all your profits are going to the creditors.

c. As for Part C, I've never seen a question like this on the exam. I'd be inclined to just try trial and error with the development time, and adjust the cash flows accordingly to see how close you can get NPV to zero. The alternative way to do this is to pick apart the long-hand, and long-winded version of the NPV formula, and do a bunch of math, including logs to get the right answer. This method is awfully tedious, and since there are relatively few cash flows, I'd prefer the trial and error method.

d. NPV according to the NPV calculator or NPV formula on excel is -$115,908.00( by assuming cost of capital as 14.6%) and as the NPV is negative, company should not make the investment.

e. 11.2-14.6= -3.6%, since IRR is smaller than cost of capital, company should not make an investment.

Think of the IRR as the return on the investment, how much we're making on it. The cost of capital is like the interest rate on your credit card. The cost of getting that money. You want your IRR to be greater than the cost of capital, otherwise, all your profits are going to the creditors.

f. (same as part 'c')

hope this helps..

cheers...!!