FastTrack Bikes, Inc. is thinking of developing a new composite road bike. Devel

Question

FastTrack Bikes, Inc. is thinking of developing a new composite road bike. Development will take six years and the costs is $203,900 per year. Once in production, the bike is expected to make $292, 682 per year for 10 years. The cash inflows begin at the end of year 7. For parts A-C, assume the cost of capital is 9.8%

a. Calculate the NPV of this investment opportunity. Should the company make the investment?

b.Calculate the IRR and use it to determine the maximum deviation allowable in the cost of capital estimate to leave the decision unchanged.

c. How long must development last to change the decision?

For parts d-f, assume the cost of capital is 14.2%

d. Calculate the NPV of this investment opportunity. Should the company make the investment

e. How much must this cost of capital estimate deviate to change the decision?

The max deviation is _______%

f. How long must development last to change the decision?

PLEASE CLEARLY STATE ANSWERS

Explanation / Answer

Hi there,

For the parts from a-c, the cost of capital is 9.8%

For years 0-5, development costs 203,900, and cash inflow from 6-16 is 292,682

A) NPV = -{203900/(9.8%)} * (1- 1/(1+9.8%)^6) + (1/(1+9.8%)^6) * (292682/9.8%) * (1- 1/(1+9.8%)^10)

= -893,267 + 1035175 = 141908

NPV > 0, so the company should take the project.

B) Setting the NPV = 0 and solving for r (using a spreadsheet) the answer is IRR = 11.99%. So if the estimate is too low by 2.19% (11.99% - 9.8%), the decision will change from accept to reject.

C) To calculate the development period to change the decision

=203900*((1+9.8%)^N-1)/9.8% = (292682/9.8%) * (1- 1/(1+9.8%)^10)

Solve for N, we get 6.71 years

If the cost of capital is 14.2%

D) NPV = -(203900/(14.2%))*(1- 1/(1+14.2%)^6) + (1/(1+14.2%)^6)*(292682/14.2%) * (1- 1/(1+14.2%)^10)

= -105663.65

As NPV>0 we should not make the investment

E) Setting the NPV = 0 and solving for r (using a spreadsheet) the answer is IRR = 11.99%. So if the estimate is changed by 2.21% (14.2 - 11.99%), the decision will change from reject to accept.

F) To calculate the development period to change the decision

=203900*((1+14.2%)^N-1)/14.2% = (292682/14.2%) * (1- 1/(1+14.2%)^10)

Solve for N, we get 5.42 years

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