EVALUATING INVESTMENT PROJECTS- CORPORATE FINANCE

You are considering starting a new business with your friend. You have developed a mood remote control that will automatically switch TV channels to a show the viewers are in the mood for. The machine required to produce your product would cost you $400,000. Given that you would set up a company for the project, you can depreciate the machine for tax purposes straight line to a salvage value of zero over the projects lifetime. You also expect the market value of the machine to be zero at the end of the project. You expect the project to have a lifetime of four years. You expect that you can sell 5,000 units of MoodRemotes each year. You will charge a price of $35 per unit in the first year. Over the next years you will raise the price by 25% per year. The production cost is $25 per unit in the first year, but you think the cost will decrease by 5% per year thereafter. The first cash flow arrives at the end of year 1 and the last at the end of year 4. The tax-rate is 30%.

a) What is the total cash flow in year 0?

b) What is the total cash flow in years 1 to 4?

c) Assume the discount rate is 15%. What is the NPV of the project? Would you invest?

d) Assume the projects income is the only taxable income you generate. If the government would not allow loss carryforwards (i.e., the minimum tax you pay in a year is $0 and losses cannot be accredited to gains in future years) would your NPV calculation from c) change? If so, how?

You realize that the price increase you used for your initial calculation is just an expectation, i.e., uncertain. The price increase that you can actually enforce in the next years will depend on the competitive environment. If competition is fierce you will not be able to raise prices at all. If competition is soft you will be able to raise prices by 50% per year. You can hire a consultant that will do a thorough market analysis and come up with a reliable demand forecast, i.e., the consultant can tell you for sure if you can increase prices by 0% or 50% per year after year 1. You know that both scenarios are equally likely.

e) The consultant charges $50,000 for her services. Would you hire the consultant before making the investment decision? (How) does this affect your calculation from c) and does this affect your overall decision whether or not to invest? (Note: ignore the additional considerations from d) here.)