7. A sports nutrition company is examining whether a new high-performance sports

Question

7. A sports nutrition company is examining whether a new high-performance sports drink should be added to its product line. A preliminary feasibility analysis indicated that the company would need to invest $17.5 million in a new manufacturing facility to produce and package the product. A financial analysis using sales and cost data supplied by marketing and production personnel indicated that the net cash flow (cash inflows minus cash outflows) would be S6.1 million in the year 4 first year of commercialization, $7.4 million in year 2, $7.0 million in year 3, and S5.5 million in Senior company executives were undecided whether to move forward with the development of the new product. They requested that a discounted cash flow analysis be performed using two different discount rates: 20 percent and 15 percent a. Should the company proceed with development of the product if the discount rate is 20 percent? Why? b. Does the decision to proceed with development of the product change if the discount rate is 15 percent? Why?

Explanation / Answer

We can make the decision using net present value analysis

NPV = Present value of cash inflows - present value of cash outflows

1)

When discount rate is 20%

NPV = -17.5 + 6.1 / ( 1 + 0.2)1 + 7.4 / ( 1 + 0.2)2 + 7 / ( 1 + 0.2)3 + 5.5 / ( 1 + 0.2)4

NPV = -0.57 million

Since the project has a negative NPV, company should NOT proceed with the project.

2)

When discount rate is 15%:

NPV = -17.5 + 6.1 / ( 1 + 0.15)1 + 7.4 / ( 1 + 0.15)2 + 7 / ( 1 + 0.15)3 + 5.5 / ( 1 + 0.15)4

NPV = 1.15 million

Since the project has a positive NPV, company should proceed with the project.

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