Reference no: EM133005290

Question - You are a member of the investment committee for a large manufacturing company that two years ago licensed a new technology from a small start-up firm. Based largely on that technology, engineers in one of your company's divisions developed a new product that is now ready for launch. If your company does not proceed with the launch within the year, the licensor has the right to suspend your license and attempt to market the technology to another manufacturer.

The product launch will require a significant investment: of $145 million for manufacturing capacity, working capital, and marketing and distribution. Net after-tax cash flows are expected to be $10, $12, and $15 million in the following three years of operation, at which point the capacity will be fully utilized. The manufacturing assets are expected to have a very long useful life, necessary maintenance expenditures are included in the after-tax cash flow projections, cash flow is expected to grow at 3% per year after year 3.

Your company uses a hurdle rate of 10% for investments in its core business. However, the investment committee considers this product launch to be riskier than the core business and has stipulated that a 15% hurdle rate will apply. The risk-free rate is currently 5%.

The new product targets a very large market and is a key part of the division's growth plans. After three years, once the original capacity is fully utilized, the firm can add twice again as much capacity for less than twice the additional expenditure. Specifically, an incremental investment of $250 million will generate additional cash flows of $20, $24, and $30 million in the subsequent three years which then grow at 3% per year, this capacity will also have a very long life.

Evaluate the proposed launch using a standard discounted cash flow approach. Explain how the committee should address the issue of which discount rate to use? Which rounds should be included?