James LaGrande had recently been appointed Controller of the Breakfast Cereals Division of a major food company. One of Jim's first assignments was to prepare the financial analysis for a new cold cereal, Krispie Krinkles. Mr. LaGrande discussed the product with the food lab that had designed it, with the market research department that had tested it, and with the finance people who would have to fund its introduction. After putting together all the information, he developed the following optimistic and pessimistic sales projections:
Year 1 $ 1,600,000 $ 800,000
Year 2 $ 3,600,000 $ 1,200,000
Year 3 $ 5,000,000 $ 1,000,000
Year 4 $ 8,000,000 $ 800,000
Year 5 $ 10,000,000 $ 400,000
The optimistic predictions assume a successful introduction of a popular product. The pessimistic predictions assume that the product is introduced, but does not gain wide acceptance and is terminated after 5 years. LaGrande thinks the most likely results are halfway between the optimistic and pessimistic predictions.
LaGrande learned from finance that this type of product introduction requires a predicted rate of return of 16% before top management will authorize funds for its introduction. He also determined that the contribution margin should be about 50% on the product, but could be as low as 42% or as high as 58%. Initial investment would include $3 million for production facilities, $2.5 million for advertising and other product introduction expenses, and $500,000 for working capital (inventory, etc.). The production facilities would have a value of $800,000 after 5 years.
Prepare a capital-budgeting analysis to determine whether or not to launch the product.
To gain a 16% rate of return, the net present value at 16% must be positive. We calculate the NPV for the three scenarios - optimistic, expected, and pessimistic. The expected is halfway between optimistic and pessimistic. The cash flows are discounted at 16%. Please refer to the Excel attachment to view the data and note that all figures in thousands of dollars.
The investment and salvage values do not depend on the optimistic and pessimistic forecasts:
Investment (1.0000 x ...