Question: Suppose you have been asked to report to the CEO of a medium-sized British company on the viability, based on net present value (NPV), of a proposed new product which the company is considering including in its forthcoming production plan. The following information is available to you and may be used as the basis for your analysis.
A market survey for the product has concluded that the whole market for the product will have a three-year life cycle, and the entire product market (i.e., the whole industry) for the next three years, respectively, is as follows: 1,000,000 units, 1,600,000 units, and 400,000 units. The marketing director has estimated a linear regression equation for the product: P = 100 - 0.25Q, where P is product price and Q is the quantity produced and sold by the company and is to be converted into 000s. He has also decided that the product should be marketed at a price of £50 during the first year (the linear regression equation is to be used to estimate output/sales in year one), but that after that the output/sales should follow the trend in the market as a whole, and price be determined using the above linear regression equation.
The following further financial data pertaining to the new product are available:
The cost of the machinery to manufacture the product will cost £3 million and in the year following the cessation of manufacturing the new product this machinery can be sold for £500,000.
Advertising expenditure is planned to be £300,000 immediately should the decision to go ahead with production of the new product be made, followed by £200,00 in year two, and £180,000 in year three paid on the first day of the respective years.
The variable costs per unit of the new product are estimated to be £30.
The company's cost of capital is estimated to be 10% over the three-year period.
N.B. Ignore taxation.
Required: Write a report aimed at the CEO of the company advising her on the viability of the production of the proposed new product. Include in your report calculations of the output and sales units for the product, and a cash flow statement showing the net present value of the proposed product based on the above information. Also, comment on the limitations of the use of a linear regression model to forecast net cash flows, and on other assumptions you have made in making your calculations.