Suppose we are asked to decide whether or not a new consumer product should be launched. Based on projected sales and costs,

Question

Suppose we are asked to decide whether or not a new consumer product should be launched. Based on projected sales and costs, we expect that the cash flows over the fiveyear life of the project will be $2,000 in the first two years, $4,000 in the next two, and $5,000 in the last year. It will cost about $10,000 to begin production. We use a 10 percent discount rate to evaluate new products. What should we do here?

Accepted Answer

Given the cash flows and discount rate, we can calculate the total value of the product by discounting the cash flows back to the present:

Present value=[latex](\$2,000/1.1)+(2,000/1.1^{2})+(4,000/1.1^{3}) +(4,000/1.1^{4})+(5,000/1.1^{5})[/latex]

=$1,818+1,653+3,005+2,732+3,105

=$12, 313

The present value of the expected cash flows is $12,313, but the cost of getting those cash flows is only $10,000, so the NPV is $12, 313-10,000=$2,313. This is positive; so, based on the net present value rule, we should take on the project.

Question 9.1: Suppose we are asked to decide whether or not a new consumer...

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