Imagine that you manage a company that has invested $5 million in developing a new product, but has not completed development. At the last meeting, your salespeople report that the arrival of new competing products has reduced expected sales of your new product to $3 million. If it would cost $1 million to finish development and make the product, should you do so? What is the most you should pay to complete development? Why? Be sure to explain.
PLEASE HELP!!!!!!!!1
To determine whether you should complete the development of the product, you will need to assess the financial viability of the project. Here's how you can calculate whether it is worth finishing the product and the maximum amount you should pay to complete development:
Step 1: Calculate the estimated net cash flow
To calculate the estimated net cash flow of the project, subtract the cost of development from the expected sales revenue. In this case, it would be:
$3 million (expected sales) - $1 million (development cost) = $2 million (estimated net cash flow)
Step 2: Calculate the net present value (NPV)
To determine the value of the project in today's dollars, you need to calculate the net present value of the estimated net cash flow. The NPV takes into account the time value of money, meaning it discounts future cash flows to their present value based on a given discount rate.
Step 3: Select an appropriate discount rate
The discount rate represents the minimum return the company expects to earn on its invested capital. It accounts for factors like the riskiness of the project, alternative investment opportunities, and the cost of capital. The specific discount rate is subjective and can vary depending on the company's perceived risk tolerance.
Step 4: Calculate the net present value (NPV)
Using the estimated net cash flow and the chosen discount rate, you can calculate the NPV. The formula for NPV is: NPV = Σ(CFt / (1 + r)^t), where CFt represents the cash flow for a specific period and t represents the time period.
Step 5: Assess the NPV result
If the NPV is positive, it indicates that the project is expected to generate more value than the initial cost. A positive NPV would suggest that you should proceed with completing the development.
If the NPV is negative, it means that the project is not expected to generate enough value to cover the development cost. In this case, you should consider whether there are any potential adjustments or improvements that can be made to increase the expected sales or minimize the development cost.
To determine the maximum amount you should pay to complete development, you can subtract the development cost from the expected sales, similar to the calculation in step 1. In this case, the most you should pay to complete development would be $2 million ($3 million - $1 million).
It's important to note that these calculations are based on estimated values, and other factors like market conditions, competition, and strategic considerations should also be taken into account when making the final decision.