Question

2. A company has just tested the market for a new product. The test indicates that the product may capture about 40 percent of the market share. It is also expected that 25 percent of the new product’s share will be at the cost of an existing product. The new product can be manufactured in the existing facilities, which could also be used to meet the expected increase in one of the company’s existing products. The company’s financial analyst argues that she would include the test costs in the new product’s cash flows since they were incurred for testing the new product but would exclude the lost contribution on an existing product and the value of the existing facilities to be used for the manufacture of the new product because no out-of-pocket cost is incurred. Do you agree with the analyst? Why or why not?

Answer 1

I do not agree with the Financial Analyst of the company for two reasons.

• The Value of existing facilities to be used for the manufacture of the new product would have been used otherwise if the product was not developed. This represents the opportunity cost of the company in developing the new product.
• To include the test cost in the project's cash flows is correct, but she should also include the lost contribution of the existing product because it is a loss because of the development of the new product.