These are the questions:
Question 1) Using net present value computations and ignoring income taxes, analyze the one year and two year development alternatives. At this time, ignore the potential introduction of a comparable product by ACE's major competitor. Should either alternative be selected? If so, which would you recommend? ACE's cost of capital is 10 percent.
Question 2) How would you modify your analysis in part (1) to address the potential introduction of a competing product by ACE's major competitor?
ACE Company:
ACE Company is the technology and market leader in the portable electronic games industry. The company is currently enjoying great success with its Model X, which has been on the market for several years. ACE's management believes that be¬cause of increased competition from other types of entertainment, the demand for Model X will dry up after three more years. The company has forecast Model X's net cash inflows in the next three years to be $400 million, $300 million, and $200 million, respectively.
New Product Development:
ACE's senior managers are considering the development and introduction of a replacement for Model X, to be called Model Z. According to the engineers, ACE already possesses the technical expertise to develop Model Z. However, the earliest that this product can be introduced into the market is one year from now, as it will take this long to develop and test the new product, coordi¬nate with suppliers for parts, set up the production process, and arrange for other related logistic activities. The total cost of these development activities is estimated at $550 million.
All of ACE's top managers agree that Model Z's market potential in terms of net cash inflow would be $200 million in year 2, $400 million in year 3, $300 million in year 4, and $100 million in year 5. They also agree that Model Z would maintain ACE's leadership position in the portable electronic games industry.
Management expects that in addition to developing its own customer base, Model Z also would draw some sales away from Model X. The expected amount of this "cannibalization" is $100 million of net cash inflows per year. The following table summarizes ACE's prediction of net cash flows (in millions) for the next five years for Model X by itself and with the introduction of Model Z at the end of year 1 (or, equivalently stated, the beginning of year 2). For simplicity, cash outflows are assumed to occur at the beginning of the year while cash inflows are assumed to occur at year end. Thus, for example, the $550 million development cost in year 1 is assumed to occur at time zero, while the net cash inflow from introducing Model Z at the beginning of year 2 is assumed to occur at the end of that year. Also note that in the table, net cash inflows of $100 mil¬lion per year are shifted from Model X to Model Z in years 2 and 3.
* Reflects $100 cannibalization of Model X by Model Z.
Model X Introduce Model Z After One Year
Year Only Model X + Model Z = Total
0 $ 0 $ 0 + $ (550) = $(550)
1 $400 $400 + 0 = $ 400
2 $300 $ 200* + 300* = $ 500
3 $200 $ 100* + $ 500* = $ 600
4 $ 0 $0 + $ 300 = $ 300
5 $ 0 $0 + $ 100 = $ 100
Extending the Development Period for Product Z
Several members of top management are concerned about Model Z's ero¬sion of Model X sales. They propose that it would be better to spread the development of Model Z over two years and to introduce it at the beginning of year 3 instead of year 2. They suggest that this plan has two major advantages: (1) it would avoid the $100 million erosion in Model X's net cash inflows in year 2; and (2) the engineers have projected that extending the time for the development process will yield substantial savings due to efficiencies in scheduling. They have estimated that the two year plan would reduce Model Z's total development cost to $300 million. Half of this total would be spent in each of the two years.
The table below summarizes the estimated net cash flows (in millions) for the two year plan. Compared to the oneyear plan, Model X's year 2 net cash inflow is higher by $100 million. This is due to avoiding cannibalization by Model Z in year 2.
Model X Introduce Model Z After One Year
Year Only Model X + Model Z = Total
0 $ 0 $ 0 + $ (150) = $(150)
1 $400 $ 400 + $(150) = $ 250
2 $300 $ 300 + 0 = $ 300
3 $200 $ 100* + $ 500* = $ 600
4 $ 0 $0 + $ 300 = $ 300
5 $ 0 $0 + $ 100 = $ 100
* Reflects $100 cannibalization of Model X by Model Z.
Proponents of the two year plan acknowledge that delaying Model Z's introduction by one year would require foregoing its year 2 $300 million net cash inflow. But they emphasize that this sacrifice is more than made up by the additional $100 million cash inflow from Model X in year 2 and the $250 million savings in Model Z development costs.
Other Considerations:
Supporters of the one year plan argue that proponents of the two year plan have overlooked a major factor: that the timing of Model Z's introduction could have an impact on competitors' actions. They maintain that if ACE does not introduce Model Z as quickly as possible, ACE's major competitor would most cer¬tainly come in with a comparable product. In response to a query from these managers, ACE's engineers have conducted a study of the competitor's current capabilities, They have reported that due to the competitor's less sophisticated technologies, it will require two years to develop a comparable product for market introduction.
The nature of the industry is such that there is a significant first mover advantage. Similar products that reach the market at the same time tend to get equal shares of the market. But once a product is introduced, it tends to get so entrenched that comparable products introduced subsequently can gain only inconsequential market shares.