Problem 1) A product improvement will raise sales and the firm's cash flows will rise by $80,000 at the end of the first year, $100,000 at the end of the second year, and $120,000 at the end of the third year. After that we expect no effect from the product innovation. The cost of the innovation is $280,000, which is less than the total cash flow generated by the innovation. This amount will be paid today. Should your firm spend $280,000 to get $300,000 back?
Solve for NPV in Excel
Problem 2) How much would the cost of the innovation have to be to make you indifferent between investing or not?
Problem 3) You are able to lower cost of innovation to $200,000 but it will take more time to do the work. This means higher profits and cash flows will be delayed by one year. The investment of $200,000 will occur today. Which option is better ($200,000 with delay or $280,000 without delay)? What is the NPV of the project with the lower cost of innovation ($200,000) and the delay?
Problem 4) The $200,000 option is not guaranteed to work. You feel there is a 95% probability it will work in which case the firm's cash flows will rise as described in 3). If the innovation fails, then cash flows will not change (ie: the increase is zero). The success of the innovation is a function solely of whether the production process works. The $200,000 will be spent today before you know whether the new innovation works. Now which option is better ($200,000 with delay and risk or $280,000 without delay)? What is the NPV of the project with the lower cost of innovation ($200,000), delay, and risk?