Problem
Perot Corporation is developing a new CPU chip based on a new type of technology. Its new chip, the Patay2 chip, will take two years to develop. However, because other chip manufacturers will be able to copy the technology, it will have a market life of two years after it is introduced. Perot expects to be able to price the chip higher in the first year, and it anticipates a significant production cost reduction after the first year as well. The relevant information for developing and selling the Patay2 is given as follows:
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Patay2 Chip Product Estimates
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Development cost
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$ 20,000,000
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Pilot testing
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$ 5,000,000
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Debug
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$ 3,400,000
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Ramp-up cost
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$ 3,000,000
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Advance marketing
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$ 5,800,000
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Marketing and support cost
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$ 1,000,000 per year
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Unit production cost year 1
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$ 655.00
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Unit production cost year 2
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$ 545.00
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Unit price year 1
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$ 820.00
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Unit price year 2
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$ 650.00
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Sales and production volume year 1
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250,000
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Sales and production volume year 2
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150,000
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Interest rate
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10%
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Assume all cash flows occur at the end of each period.
1. What is the net present value (at the discount rate of 10%) of this project?
2. Perot's engineers have determined that spending $10 million more on development will allow them to add even more advanced features. Having a more advanced chip will allow them to price the chip $50 higher in both years ($870 for year 1 and $700 for year 2). What is the NPV of the project if this option is implemented?
3. If sales are only 200,000 the first year and 100,000 the second year, what would the NPV of the project be? Assume the development costs and sales price are as originally estimated.