Question

The McGregor Whisky Company is proposing to market diet scotch. The product will first be test-marketed for two years in southern California at an initial cost of $630,000. This test launch is not expected to produce any profits but should reveal consumer preferences. There is a 56% chance that demand will be satisfactory. In this case McGregor will spend $6.3 million to launch the scotch nationwide and will receive an expected annual profit of $830,000 in perpetuity. If demand is not satisfactory, diet scotch will be withdrawn.

Once consumer preferences are known, the product will be subject to an average degree of risk, and, therefore, McGregor requires a return of 14% on its investment. However, the initial test-market phase is viewed as much riskier, and McGregor demands a return of 22% on this initial expenditure.

What is the NPV of the diet scotch project? (A negative answer should be indicated by a minus sign. Do not round intermediate calculations. Round your answer to the nearest whole dollar amount.)

Net present value            $

Answer 1

We need to calculate NPV of 2 scenario

First scenario is demand is not satisfactory

Initial outflow=630,000

There will be no cash inflow

NPV= PV of cash Inflow- PV of cash outflow

NPV= 0-630,000 = - 630,000

Second scenario is demand is satisfactory

Present value of cost to launch national wide incurred after 2 year

Present value of investment

Next we need to calculate average return rate on investment

Return required on initial cost of test=22%

Return required on cost of launching=14%

Now calculate present value of cash inflow at the end of 2nd year taking rate as 14.92%

Where C is cash flow

r is interest rate

NPV= 5563003-5477645 = 85,358

Now we will calculate expected NPV

Therefore expected NPV is -229,400