Sparks Company is planning to invest in the development of a new product which w

ID: 2718267 • Letter: S

Question

Sparks Company is planning to invest in the development of a new product which will take 5 years to develop and will cost $250,000 per year during the development stage. Thereafter, the new product is expected to generate revenues of 350,000 per year for 12 years. The cost of capital is estimated to be 8%.

a) Is the project worth undertaking? Use the NPV rule.

b) What is the IRR? Use this value to determine by how much the cost of capital can deviate from 8% before the decision about the project (that you found in (a)) must be changed.

c) Suppose that the CFO of Sparks thinks that the development period may last more than 5 years. How long must the development stage last to change the decision? (Assume that the cost of capital is 8%).

Explanation / Answer

Determination of the net present value is as follows:

Particulars

Period

Cash flows per year

Annuity discount rate @8%

Discounted flows

Expected revenues

12 years

350,000

7.536

2,637,600

Expected costs

5 years

-250,000

3.9927

-998,175

Net present value

1,639,425

The project is worth undertaking as the NPV is positive.