The Whiskey Company is evaluating a proposal to distill and manufacture diet sco

Question

The Whiskey Company is evaluating a proposal to distill and manufacture diet scotch.  Before investing in full scale production of the new porduct, diet scotch will first be test marketed for 2 years in Maine at an immediate up front cost of $750000. Test marketing the poduct is not expected to produce any profits but will reveal the strenth of consumer preferences for diet scotch.  There is only a 40% chance that dema d will be satisfactory, in which case Whiskey Co will spend $10 million to launch national distributino of the diet scotch, which would generate expected yearly profits of $1,500,000 in perpetuity.  If demand is not satisfactory, the distillation and production of diet scotch will be terminated immediately.  Once consumer preferences are known, the risk of the product cash flows will be similar to the average risk level for Whiskey Co's existing products, which havea required return of 10%.  However, Whiskey Co's CFO is convinced that the initial test market phase is much riskier than normal.  Assuming the Whiskey Co's demand a return of 35% percent on the test marketing phase of new products, determine the NPV of decision to test market diet scotch?

Explanation / Answer

Assuming the demand is satisfactory, then in year 2, cash outflow = -10 million

Cash inflows from year 3 million in perpetuity

As the consumer preferences are known, these can be discounted at the average risk level of Whiskey Co's existing products of 10%

So NPV of the cashflows as of 2 years from now = -10 million + 1.5 million/10% = 5 million

As there is only a 40% chance of this happening (i.e. the demand turning out to be satisfactory), we should weight this NPV with a weight of 40%

Now, the NPV as of time T=0 is either this NPV of $5million in 2 years with a probability of 40% or an NPV of 0 with a probability of 60%, along with the upfront investment of 750,000. As we are not aware of the consumer demand at this time, we should discount this at the test marketing rate of 35%.

So NPV as of time T=0 is -750,000 + 5,000,000*40%/(1+35%)^2 = $ 347,394

Hope this helped ! Let me know in case of any queries.

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