Question

Tribiani Manufacturing (TM) is evaluating a new product. If TM goes to market today, it will cost $15 million and the product is expected to create cash flows of $5.3 million per year for the next 5 years. Alternatively, the company could spend $1 million today for a market analysis. The analysis would take two years and result in a better estimate of the product demand. There is a 70 percent chance that the market analysis would find the product would produce cash flows of $7.1 million per year for 6 years and a 30 percent chance that the cash flows would be $3.8 million for 5 years. In 2 years, it would cost $16 million to take the product to market. The required return is 11 percent. Should TM take the product to market now or conduct the analysis?

*Please show excel formulas with answer*

Answer 1

We first calculate the NPV of the first option (15.00) 5.30 5.30 5.30 5.30 5.30 We will use the excel formula to calculate the present value NPV of the project at 11% 4.59 Million Now we will calculate the expected cash flows at each time period Time period 0 1 2 -1 -16 (0.7* 7.1 +0.3*3.8) (0.7* 7.1 +0.3*3.8) (0.7* 7.1 +0.3*3.8) (0.7* 7.1 +0.3*3.8) (0.7* 7.1+0.3*3.8) (0.7* 7.1 +0.3*0) Cahs flows (1.00) (16.00) 6.11 6.11 6.11 6.11 6.11 6.11 6.11 4.97 Now we will calculate the net present value of these cash flows @ 11% 6.498657 6.50 Million The net present value of the second option is higher, so TM should conduct the analysis.