Product A
This product will take 2 years to develop, at a cost of $100,000 in the first year (Yr 0) and $50,000 in the second. Revenue (benefits) in subsequent years is expected to be $100,000 per year.
Product B
This product will only take a year (Yr 0) to develop, at a cost of $120,000. Revenue (benefits) in subsequent years in expected to be $60,000 per year.
Assuming the company uses a 5-year planning horizon, which product should Megasoft initiate a project to develop?
Year 0 Year 1 Year 2 Year 3 Year 4 Total
Product A
Costs
Benefits
Cash Flow
Discount factor 1.00 0.83 0.69 0.58 0.48
DB - DC NPV
Product B
Costs
Benefits
Cash Flow
Discount factor 1.0 0.83 0.69 0.58 0.48
DB - DC
NPV
To determine which product Megasoft should initiate a project to develop, we need to calculate the Net Present Value (NPV) for each product. NPV is a financial metric that takes into account the cost of investment and expected future cash flows, discounted to the present value.
Let's calculate the NPV for each product:
Product A:
Year 0: Cost = -$100,000
Year 1: Cost = -$50,000
Year 2: Benefit = $100,000
Discount factor:
Year 0: 1.00
Year 1: 0.83
Year 2: 0.69
NPV = (Benefit * Discount factor) - (Cost * Discount factor)
NPV = ($100,000 * 0.69) - ($100,000 + $50,000) * (1.00 + 0.83)
NPV = $69,000 - $150,000
NPV = -$81,000
Product B:
Year 0: Cost = -$120,000
Years 1-4: Benefit = $60,000
Discount factor:
Years 0-4: 1.00, 0.83, 0.69, 0.58, 0.48
NPV = (Benefit * Discount factor) - (Cost * Discount factor)
NPV = ($60,000 + $60,000 + $60,000 + $60,000) * (1.00 + 0.83 + 0.69 + 0.58 + 0.48) - $120,000
NPV = $240,000 * 3.58 - $120,000
NPV = $859,200 - $120,000
NPV = $739,200
Comparing the NPV of both products, we can see that Product A has a negative NPV of -$81,000 while Product B has a positive NPV of $739,200. This means that Product B is the better investment for Megasoft, as it has a higher potential for returns and is more financially viable. Hence, Megasoft should initiate a project to develop Product B.