Reference no: EM131328396
Consumer Products Inc. (CPI) is considering performing a feasibility study for a new product available from one of its foreign suppliers. Because CPI will have to make an initial investment of $20 million to obtain exclusive U.S. marketing rights to the product, the firm is contemplating performing a feasibility study of the product's market potential. The cost of the study, which will take two years to complete, is an up-front fee of $2 million.
Included in this cost is an exclusive option that gives CPI two years in which to make the decision to pay the foreign supplier the $20 million. If CPI performs the feasibility study, its preliminary estimates indicate that there is a 50 percent chance of strong product demand, which will result in cash inflows of $5.2 million per year for eight years; there is a 20 percent chance of moderate product demand, which will result in cash inflows of $4.5 million per year for eight years; and there is a 30 percent chance of weak demand, which will result in cash inflows of $4.0 million per year for eight years.
Note that the $20 million would be paid at the end of year 2, immediately after the feasibility study is completed and that all outcomes will provide only eight years of cash inflows. CPI's cost of capital applicable to the proposed new product decision is 12 percent.
a. Draw the decision tree associated with CPI's proposed feasibility study.
b. Calculate the NPV associated with each of the possible product demand outcomes-strong, moderate, and weak.
c. Find the expected NPV of performing the feasibility study.
d. Based on your findings in part (c), what recommendation would you give CPI about the proposed feasibility study? Explain.
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