The McGregor Whisky Company is proposing to market diet scotch. The product will

Question

The McGregor Whisky Company is proposing to market diet scotch. The product will first be test-marketed for two years in southern California at an initial cost of $720,000. This test launch is not expected to produce any profits but should reveal consumer preferences. There is a 61% chance that demand will be satisfactory. In this case McGregor will spend $5.1 million to launch the scotch nationwide and will receive an expected annual profit of $630,000 in perpetuity. If demand is not satisfactory, diet scotch will be withdrawn.

Once consumer preferences are known, the product will be subject to an average degree of risk, and, therefore, McGregor requires a return of 11% on its investment. However, the initial test-market phase is viewed as much riskier, and McGregor demands a return of 19% on this initial expenditure.

What is the NPV of the diet scotch project? (A negative answer should be indicated by a minus sign. Do not round intermediate calculations. Round your answer to the nearest whole dollar amount.)

Please list all formulas and steps in order to reach solution.

Explanation / Answer

In case of launch, NPV of the project in year 2 = - 5,100,000 + 630,000 / 11% = $627,273

Now, there is only 61% probability for a launch, hence

NPV of the diet scotch project today = -720,000 + 627,273 x 61% / (1 + 19%)^2 = - $449,796

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