The McGregor Whisky Company is proposing to market diet scotch. The product will

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 $610,000. This test launch is not expected to produce any profits but should reveal consumer preferences. There is a 58% chance that demand will be satisfactory. In this case McGregor will spend $6.1 million to launch the scotch nationwide and will receive an expected annual profit of $810,000 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 If demand is not satisfactory, diet scotch will be withdrawn.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 12% on its investment. However, the initial test-market phase is viewed as much riskier, and McGregor demands a return of 21% on this initial expenditure.

What is the NPV of the diet scotch project?

   Once consumer preferences are known, the product will be subject to an average degree of risk, and, therefore, McGregor requires a return of 12% on its investment. However, the initial test-market phase is viewed as much riskier, and McGregor demands a return of 21% on this initial expenditure.

Explanation / Answer

at t = 2, there are 2 possible value of NPV,

a) with 42% probability(when the project is not successful)

NPV2(if not successful) = 0

b) with 58% probability( so that the demand is satisfied)

NPV2(if test is successful) = -6100000+(810000/.12) = 650000

therefore, at t=0

NPV0 = -610000+(((.42*0)+(.58*650000))/1.21^2) = -$352,503.92

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