Northern Lights, Inc., a producer of electric bulbs in Michigan, is currently evaluating the introduction of a line of more efficient bulbs. Most of its competitors have already entered and to remain competitive management believes it is necessary for Northern Lights to also enter the efficient bulbs market. Industry analysts predict steady growth in the sales of efficient bulbs in the years to come.

Production facilities for the proposed project will be housed in a currently unused section of Northern Lights plant; this section was renovated last year at a cost of $150,000 and is currently leased to a local company for $20,000 a year. The lease is scheduled to expire in five years from today; however, if Northern Lights breaks the lease now, it must pay $15,000 to the lessee. The

machinery required for the production of the new bulbs costs $470,000; its shipping cost is estimated to be $10,000, while its installation cost is $40,000. The machinery falls in the 3-year MACRS class, has an economic life of four years, and its salvage value is estimated to be $100,000 after four years of use. In addition, Northern Lights must increase inventories by $10,000 at the time of the initial investment in the machinery. Thereafter, inventories should be three percent of next years revenues over the life of the project.

Northern Lights expects to sell 400,000 of the new bulbs in the first year of operations; thereafter unit sales are estimated to grow at a two percent annual rate. If the project is undertaken, average production cost and selling price would be $1.50 and $2.00 per bulb, respectively at current (t = 0) dollars; nevertheless, Northern Lights estimates that price will increase at the five percent inflation rate while production costs will increase by only two and a half percent annually beginning immediately.

Northern Lights sales manager is concerned that the introduction of the efficient bulbs will cannibalize the sales of the firms regular bulbs. She estimates that regular bulb sales will decline by $40,000 in the first year, dropping by an additional one and a half percent annually thereafter. As a result, Northern Lights production manager estimates that regular bulbs production costs will decline by $20,000 in the first year, falling by an additional one percent annually thereafter.

Northern Lights debt-to-value ratio is .50. The before-tax yield on Northern Lights long-term debt is 10%. The firms equity beta is 2 and its marginal tax rate is 20%. Analysts consensus for the market return is 7.5% and the one-year yield on T-bills is 1% over the life of the project.

1. Based on your calculations for 5 above, management appears to be concerned with the base case sales of 400,000 bulbs at t = 1 and asks you to provide more detailed information regarding the possible sales scenarios. The sales manager is present in the meeting and provides the following information:

Demand for efficient bulbs Low Average High Sales in bulbs 200,000 400,000 600,000 Probability 0.25 0.50 0.25

Provide NPV calculations for the project under these three scenarios and address managements concerns.