Company X is a leader in the statistical software industry. They have only one product. Their current sales are $12 million, and are expected to remain the same. They are considering launching a new product with the same riskiness level as the first. They have already spent $1 million to hire a consulting firm to perform a detailed business analysis. Company X found out the following from this.

Launching the new product will require them to pay $1.2 million in royalty fees each year for the next 3 years. Royalty fees not included in COGS or SG&A.

They expect revenue from the new product to be $9.6 million each year for the next 3 years. Production and sales of the new product will end after that.

The production cost (including COGS and SG&A) of the new product is expected to be 25% of sales, where the production cost (including COGS and SG&A) of the original product is 20% of sales. Introducing the new product will reduce the sales of the old product by 25% in each of the next 3 years.

To produce the new product, Company X needs to invest $9.6 million in supercomputers now. These supercomputers can only be used in production of the new product and will be depreciated to zero with a 4 year straight-line depreciation schedule. At the end of year 3, Company X will have the option to sell these supercomputers for $3.6 million.

Company X's net working capital (NWC) has always been maintained at a constant level of $1.2 million. The new product will require the NWC to be $3.6 million, $2.4 million, and $1.8 million in years 1, 2, and 3 respectively. The level of NWC after year 3 will be $1.2 million.

Corporate tax rate is 35%

Company X's current debt-to-equity ratio is 1/5. It's debt is riskless, and its equity beta is 1.8. The risk-free rate is 3% and market risk premium is 6%.

Company X plans to finance the new product using 40% debt and 60% equity. The debt beta for the new product is estimated to be 0.25.

a. How much incremental free cash flow (FCF) do you expect the new product to generate in year 0, year 1, year 2, year 3, and year 4?

b. What discount rate should Company X use to discount the cash flows from the new product?

c. What is the NPV of the new product?

d. If the new product requires the NWC to be $3.6 million, $2.4 million, $1.8 million in years 1, 2, and 3 respectively. and return to $1.2 million thereafter, should Company X invest in the new product?