You manage a new product development team for an electronics manufacturer, and your firm's policy is that all new projects must pay for themselves in the first five years. Your team has projected that the first year of the project requires an initial investment of $2 million with no revenue, the second year loss is $500,000, the net revenue for year 3 is zero, and you earn $1.8 million in both year 4 and year 5. If the opportunity cost of capital for your firm is 8%, should you go ahead with this project?

Question

Quizplus · Accepted Answer

To determine whether to go ahead with the project, we need to calculate the expected net present value (NPV) using the cash flows and the opportunity cost of capital.

Year 0: -$2,000,000 (initial investment)
Year 1: -$2,000,000 x 8% = -$160,000 (opportunity cost of capital)
Year 2: -$500,000 x 1.08^2 = -$578,880 (the loss adjusted for the time value of money)
Year 3: $0
Year 4: $1,800,000 x 1.08^-4 = $1,386,078 (the revenue adjusted for the time value of money)
Year 5: $1,800,000 x 1.08^-5 = $1,283,422 (the revenue adjusted for the time value of money)

Expected NPV = -$2,000,000 - $160,000 - $578,880 + $1,386,078 + $1,283,422 = $130,620

Since the expected NPV is positive, and greater than the required $2,000,000 initial investment, the project should be approved. Therefore, the best choice is B.

You Manage a New Product Development Team for an Electronics