PART D

A company plans to launch a new product line and has two options to choose from – Product A or Product B. Each product will require $25m in development costs up-front. The cash flow profiles of the products differ significantly: Product A is expected to have a steady stream of cash each year. Product B is expected to disrupt the market and grab large cash flows early, but these will taper off as the product itself is expected to be disrupted with emerging technology.

The company uses a ten-year investment horizon for its new products. The annual cash flows for each product, expressed in $m, are as follows:

The cost of financing product development is 10% and consequently this represents the hurdle rate for each investment.

1. The CEO is a big fan of the internal rate of return (IRR) technique for evaluating investments because of a belief it is easier to convey to the Board. Which product would be selected if IRR is used as the investment evaluation tool?

2. Peter Craig, a recent MBA graduate and advisor to the CEO, strongly recommends using the net present value (NPV) technique. Which product would be selected if NPV is used as the investment evaluation tool?

3. Despite Peter’s strong influencing skills, the CEO remains adamant that the Board want to compare returns on each product relative to the hurdle rate of 10% that the firm uses. How might Peter meet the CEO’s request, while ensuring the best product is selected for development?