Question

FastTrack​ Bikes, Inc. is thinking of developing a new composite road bike. Development will take six years and the cost is

$ 209 comma 000$209,000

per year. Once in​ production, the bike is expected to make

$ 302 comma 966$302,966

per year for

1010

years. The cash inflows begin at the end of year 7.

For parts​ a-c, assume the cost of capital is

10.7 %10.7%.

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.

c. How long must development last to change the​ decision?

For parts​ d-f, assume the cost of capital is

13.2 %13.2%.

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?

Answer 1

Please see the table below.The cells highlighted in yellow contain your answer. Figures in parenthesis, if any, mean negative values. All financials are in $. Adjacent cells in blue contain the formula in excel I have used to get the final output.

a. Calculate the NPV of this investment opportunity. Should the company make the​ investment?

NPV = $ 89,984.05; Since the project has positive NPV, the company should make this 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.

IRR = 12.14%; the maximum deviation allowable in the cost of capital estimate to leave the decision unchanged = IRR - Current cost of capital = 12.14% - 10.7% = 1.44%

c. How long must development last to change the​ decision?

This has to be done manually.

Since NPV is currently positive, we can extend the development phase by 1 year and see the output.

Please see the table below.

The NPV has turned negative. Hence, the development must last for 7 years to change the decision.

Part (d)

Cost of capital now is 13.2%

NPV = - 55,766.58 Since the project has negative NPV, the company should not make this 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.

IRR = 12.14%; the maximum deviation allowable in the cost of capital estimate to leave the decision unchanged = IRR - Current cost of capital = 12.14% - 13.2% = - 1.06%

c. Since the NPV is negative, we need to reduce the development period to make it turn positive.

Please see the table below:

The NPV has turned positive. Hence, the development must last for 5 years to change the decision.