Case Study
You are the owner of Ding Dong Ltd. A small manufacturer that makes and installs doorbells. You are considering introducing a brand-new product to your catalogue. You have a choice of two potential products to choose from. Resources are only available to select one option.
Product A, has the following forecast cash flow items :
The initial investment = $30 000. The product is expected to have a five-year life cycle before it will be ended and replaced.
The product is predicted to earns sales revenue of $5 000 (Year 1); $7 000 (Year 2); $13 000 (Year 3); $15 000 (Year 4) and $20 000 (Year 5).
The raw material costs are expected to be $1 000 (Year 1); $2 000 (Year 2); $4 000 (Year 3); $5 500 (Year 4) and $8 000 (Year 5).
The other variable costs are expected to be $750 (Year 1); $800 (Year 2); $1 000 (Year 3); $1 750 (Year 4) and $2 600 (Year 5).
More capital is planned to be raised by issuing company shares to the value of $10 000 in Year 3 to your grandfather who will be a silent shareholder.
Capital equipment is depreciated at 20% per annum on the straight-line method.
Product B, has the following forecast cash flow items :
The initial investment = $50 000. The product is expected to have a seven-year life cycle before it will be ended and replaced.
The product is predicted to earns sales revenue of $0 (Year 1); $0 (Year 2); $13 000 (Year 3); $15 000 (Year 4) and $20 000 (Year 5); $26 000 (Year 6) and $32 000 (Year 7).
The raw material costs are expected to be $1 650 (Year 1); $2 250 (Year 2); $3 750 (Year 3); $4 000 (Year 4) and $5 150 (Year 5) and $5 550 (Year 6) and $5 750 (Year 7).
The other variable costs are expected to be $250 (Year 1); $300 (Year 2); $500 (Year 3); $880 (Year 4) and $970 (Year 5); $1 350 (Year 6) and $1 500 (Year 7).
A marketing campaign will be launched in Year 3. The budget will be $10 000.
A bank loan will be taken to pay for the initial investment in equipment. Repayment will begin in Year 2 with installments of $8 900 per year. Interest is included in the loan installment. The final loan repayment will take place in Year 7.
The business will qualify to receive a New Innovators Economic subsidy to the value of $20 000 from the municipality in Year 6.
Capital equipment is depreciated at 20% per annum on the straight-line method.
In both scenarios, assume a discount rate of 10%. Which option should you choose based on the NPV method ?
NPV = Cash Flow / (1 + i) ^ t - Initial Investment
Suggested Solution
Based on the NPV calculations, both product options show a positive NPV. Either product line can be accepted because both will generate positive value for the business.
Given that only one choice is available, it is better to choose Product B because it has a higher net present value.
