Question

Thanks to acquisition of a key patent, your company now has exclusive production rights for barkelgassers (BGs) in North America. Production facilities for 220,000 BGs per year will require a $24.5 million immediate capital expenditure. Production costs are estimated at $79 per BG. The BG marketing manager is confident that all 220,000 units can be sold for $114 per unit (in real terms) until the patent runs out five years hence. After that, the marketing manager hasn’t a clue about what the selling price will be. Assume the real cost of capital is 12%. To keep things simple, also make the following assumptions:

• The technology for making BGs will not change. Capital and production costs will stay the same in real terms.
• Competitors know the technology and can enter as soon as the patent expires, that is, they can construct new plants in year 5 and start selling BGs in year 6.
• If your company invests immediately, full production begins after 12 months, that is, in year 1. (Assume it takes all firms one year to achieve full production.)
• There are no taxes.
• BG production facilities last 12 years. They have no salvage value at the end of their useful life.

What is the NPV of the BG project? (Do not round intermediate calculations. Enter your answer in millions rounded to 2 decimal places.)

Net Present Value ______ Million

Answer 1

Net Present Value is $3.26 Million.

Net Present value = present value of cash flows - capital expenditure or initial investment

present value of cash flows = year 1 cash flow/(1+cost of capital) + year 2 cash flow/(1+cost of capital)2 .... + year 5 cash flow/(1+cost of capital)5

	Years	0	1	2	3	4	5	Total
	Capital Expenditure	-$24,500,000	0	0	0	0	0	-$24,500,000
	Production units	0	220,000	220,000	220,000	220,000	220,000
	Sales price/unit	0	$114.00	$114.00	$114.00	$114.00	$114.00
	Production cost/unit	0	$79.00	$79.00	$79.00	$79.00	$79.00
	Sales	$0	$25,080,000	$25,080,000	$25,080,000	$25,080,000	$25,080,000	$125,400,000
Less:	Production cost	$0	$17,380,000	$17,380,000	$17,380,000	$17,380,000	$17,380,000	$86,900,000
	Operating cash flow	-$24,500,000	$7,700,000	$7,700,000	$7,700,000	$7,700,000	$7,700,000	$14,000,000
	NPV	$3,256,776.76

Calculations