Question

Annuity and NPV (A) You are planning to produce a new action figure called "Hillary". However, you are very uncertain about the demand for the product. If it is a hit, you will have net cash flows of $60 million per year for three years (starting next year, i.e., at t = 1). If it fails, you will only have net cash flows of $10 million per year for two years (also starting next year). There is an equal chance that it will be a hit or failure (probability = 50%). You will not know whether it is a hit or a failure until after the first year's cash flows are in, i.e., at t = 1. You have to spend $90 million immediately for equipment and the rights to produce the figure. If the discount rate is 10%, calculate Hillary's NPV. The 3-year annuity factor at 10% equals 2.48685. The 2-year annuity factor at 10% equals 1.73554

How to I find the solution Using NPV Step by step, as well as taking into consideration annuities? :)

This is for Business Finance

Answer 1

If the product is hit, then the PV of future cash inflows = $60 * Present value annuity factor for 3 years @10% (assuming that the equipment purchased has nil salvage value at the end of 3 years)

PV (product is hit) = $60 * 2.48685 = $149.21

If the product is failure, then the PV of future cash inflows = $10 * Present value annuity factor for 2 years @10%(assuming that the equipment purchased has nil salvage value at the end of 2 years)

PV (product is failure) = $10 * 1.73554 = $17.36

NPV = PV (product is hit) * Probability (product is hit) + PV (product is failure) * Probability (product is failure) -intial investment

NPV = $149.21 * 50% + $17.36 * 50% - $90

NPV = $83.28 - $90

NPV = - $6.72