(1) Project Valuation

The mechanics of valuing projects is similar to valuing loans, although the underlying numbers are more complicated as we will see in class. Your firm is contemplating making a change to one of its current products (an improvement in the eye of the consumer) and has asked you to determine if the change makes financial sense. The product improvement will raise sales and the firms cash flows will rise by $80,000 at the end of the first year, $100,000 at the end of the second year, and $120,000 at the end of the third year. After that we expect no effect from the product innovation. The cost of the innovation is $280,000, which is less than the total cash flow generated by the innovation. This amount will be paid today. For all parts of this problem, assume that the correct discount rate is 10%.

a. Applying Basic Net Present Value Formula: Should your firm spend $280K to get $300K back? Why?

b. Cost of Innovation: How much would the cost of the innovation (the initial cash outlay) have to be to make you indifferent between investing or not, all else equal? If you said invest, this should be a larger number. If you said do not invest, this should be a smaller number.

c. Cost of Innovation with Delay: After some quick thinking, you realized you could lower the cost of the innovation to $200,000, but it will take more time to do the work. This means the higher profits and cash flows will be delayed for one year. The investment of $200K (as opposed to $280K) must still be paid today if you go through with it. What is the NPV of the project with the lower cost of innovation ($200,000) and delay?

d. Cost of Innovation with Delay and Risk: After some additional analysis, you realize that the $200,000 option is not guaranteed to work. You feel there is a 95% probability it will work in which case the firms cash flows will rise as described in the previous question. If the innovation fails, then cash flows will not change (i.e. the increase is zero in all future years). The success of the innovation is a function solely of whether the new production process works. The $200,000 must be spent today before you know whether the new innovation works. What is the NPV of the project with the lower cost of innovation ($200,000), delay, and risk?