Question

10. *Superfast Bikes is thinking of developing a new composite road bike. Development will take six years and the cost is $200 000 per year. Once in production, the bike is expected to make $300 000 per year for 10 years. The cash inflows begin at the end of year 7. Assume that the cost of capital is 10%. 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. How long must development last to change the decision? (Not covered in lecture, so please ignore this part) Assume that the cost of capital is 14%. 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? f. How long must development last to change the decision?

Please explain how these can be answered, in a step by step basis.

Answer 1

Q-1 Here as shown below the NPV of the project is 2,28,835.64 hence it is positive and the company should make the investment.

Q-2 The IRR of the project is 13.36% which is more than the cost of capital of 10% hence the maximum deviation allowable in the cost of capital is 13.36%-10% = 3.36% for the investment to remain unchanged.

Q-3 If the cost of capital is 14% then the development must last for another 2 years so that new IRR becomes 14.37% and the project can become viable.

The calculation is shown below:

A B D E F G Cash Flows 1 Cost of capital 10% 2 3 1 -2,00,000 Q-1 -2,00,000 NPV 2,28,835.64 4 5 -2,00,000 6 4 -2,00,000 -2,00,000 Q-2 7 5 -2,00,000 IRR 13.36% 8 6 7 3,00,000 10 8 3,00,000 11 3,00,000 3,00,000 12. 10 3,00,000 13 11 14 12 3,00,000 15 13 3,00,000 3,00,000 16 14 3,00,000 17 15 3,00,000 18 16 3,00,000 19 17 st co