Question

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

$200,000per year. Once in​ production, the bike is expected to make $ 300,000

per year for10 years. The cash inflows begin at the end of year 7. For parts​ a-c, assume the cost of capital is 10.0 %

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

14.0 %

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

a. For the first 6 years, cash outflow is $200,000 per year

Thus, NPV with rate of 10%= $-871,052.14

For the next 10 years, cash inflow is $300,000 per year

Thus, NPV with rate of 10%, = $1040534.38

As the NPV is positive, company should invest

b. IRR = 12.66%

Therefore maximum deviation allowed is 12.66-10= 2.66%

c. If the development takes one more year, then the NPV becomes negative. Thus for the management to change the decision, development should last for 7 years.

d. If the rate becomes 14%, NPV becomes negative i.e. $-64815.87. company should not invest

e. AS the IRR is 12.66%, cost of capital should deviate by more than 14-12.66%= 1.34%. i.e. Cost of capital should decrease by more than 1.34% to change the decision and to make the NPV positive.

f. To change the decision, development should last for 5 years so that NPV becomes positive at 14% cost of capital