A computer chip manufacturer is selling 10 million chips per year priced at $10

Question

A computer chip manufacturer is selling 10 million chips per year priced at $10 each. It is about to introduce a new chip that will be priced at $15 each and it expects to sell 16 million. However, demand for the old chips will fall and sales of the old chips are expected to fall to 5 million per year. The old chip costs $7.50 each to manufacture and the new ones will cost $9 each. What is the correct cash flow to use to evaluate the present value of the introduction of the new chip? Show all work for full rating.

Explanation / Answer

The proper cash flow to use here is the Incremental Cash Flow, which represent the CHANGE in the firm's total cash flow that happens as a result of undertaking a project. In this case, if the company introduces the new chip, the firm's total cash flow will rise by 16*(15-9) = $96 million (16 million chips sold at $15, cost $9 each). However, since sales of the old chip will fall by 7 million units. Therefore, the firm's cash flow, as a result of undertaking this project, will also fall 5*(10-7.5) = $12.5 million (5 million chips sold at $10, cost $7.5 each). Therefore, the incremental annual cash flow of this project is 96-12.5 = $83.5 million; and this is the value that should used in order to evaluate the project.

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