The ABC Computer Corporation is considering an increase in its annual
advertising expenditure from $10 million to $15 million for a five-year
period(i-e. in years 1 to 5. The marketing department estimates that the
increased advertising will increase profits by $4 million in years 3 to 7 and by
$3 million in years 8 to 10, after which profits will return to the level they
were at prior to the new program. if the firm uses discount rate of 10 percent,
will the proposed advertising program increase shareholder value?
To determine if the proposed advertising program will increase shareholder value, we need to calculate the net present value (NPV) of the program. NPV helps us assess the profitability of an investment by calculating the present value of its projected cash flows.
Here's how you can calculate the NPV for this scenario:
1. Identify the cash flows: In this case, the cash flows occur in years 3 to 10, so we need to calculate the present value of the incremental profits generated during these years. The cash flows are $4 million for years 3 to 7 and $3 million for years 8 to 10.
2. Calculate the present value (PV) for each cash flow: PV is the current-day value of future cash flows. To calculate PV, we use the formula:
PV = CF / (1 + r)^n
Where:
- CF is the cash flow for the specific year.
- r is the discount rate.
- n is the number of years from the present.
3. Calculate the NPV: Sum up the present values of all cash flows and subtract the initial investment.
Now let's calculate the NPV step-by-step:
Step 1: Calculate the present values of cash flows for years 3 to 10:
- Cash flow for years 3 to 7 = $4 million
- Cash flow for years 8 to 10 = $3 million
Using the formula mentioned above, we can calculate the present values:
PVyears3to7 = $4 million / (1 + 0.10)^3 + $4 million / (1 + 0.10)^4 + $4 million / (1 + 0.10)^5 + $4 million / (1 + 0.10)^6 + $4 million / (1 + 0.10)^7
PVyears8to10 = $3 million / (1 + 0.10)^8 + $3 million / (1 + 0.10)^9 + $3 million / (1 + 0.10)^10
Step 2: Calculate the NPV:
NPV = PVyears3to7 + PVyears8to10 - Initial investment
Since the initial investment is an increase in annual advertising expenditure from $10 million to $15 million for 5 years, the total initial investment is $5 million multiplied by 5 years = $25 million.
NPV = PVyears3to7 + PVyears8to10 - $25 million
Step 3: Compare the NPV with zero:
- If NPV > 0, the proposed advertising program increases shareholder value.
- If NPV < 0, the proposed advertising program does not increase shareholder value.
Compute the NPV using the data above and evaluate if the proposed advertising program increases shareholder value.