Financial Analysis of New Product Development Investment

 

Financial Analysis of New Product Development Investment

Let’s walk through an example where a company is investing in the development of a new product. The company plans to launch the product in 12 months and expects profits in the following manner:

• Year 1 to Year 3: £10,000 per year.
• Year 4 and Year 5: £8,000 per year.
• Development Cost: £30,000 (all in today's values).

The company wants to know if the project is justified based on a required return of 10%. The investment and future returns are being evaluated using the Net Present Value (NPV) method, where a positive NPV would indicate that the project generates more value than the required return, making it a justified investment.

Step-by-Step Breakdown

To calculate the NPV, we need to calculate the Present Value (PV) for each year’s cash flow. The formula for calculating the PV is:

$$\text{PV} = \frac{\text{Cash Flow}}{(1 + r)^n}$$

Where:

• r is the required return (10% or 0.10).
• n is the year number.

We will now construct the table to calculate the cash flows, discount factors (DF), present values (PV), and the cumulative present value (Cumulative PV) for each year.

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Table: Cash Flow, Discount Factor (DF), and Present Value (PV)

Year	Cash In (£)	Discount Factor (DF)	Present Value (PV, £)	Cumulative PV (£)
0	-30,000	1.000	-30,000	-30,000
1	10,000	0.909	9,090	-20,910
2	10,000	0.826	8,260	-12,650
3	10,000	0.751	7,510	-5,140
4	8,000	0.683	5,464	324
5	8,000	0.621	4,968	5,292

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Explanation of the Table:

1. Year 0: The company spends £30,000 on the development, which is an outflow. The discount factor (DF) is 1 because the cash flow happens today, and the present value (PV) is simply -£30,000.

2. Year 1 to Year 3: The company expects to generate £10,000 in profits each year. The discount factors decrease slightly each year because these profits are received in the future, so their value is discounted. The PV for each year is calculated as the cash flow multiplied by the discount factor (DF).

3. Year 4 and Year 5: In these years, the company expects profits of £8,000 per year. The discount factors for these years are lower due to the passage of time, but the PV is still positive.

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Net Present Value (NPV)

The NPV is the sum of the present values for each year:

$$\text{NPV} = \sum \text{PV}$$

From the table, the cumulative PV at Year 5 is £5,292. This is the total value of the project after 5 years, considering the 10% required return. Since the NPV is positive, the project justifies the investment.

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Conclusion

The project generates an NPV of £5,292, which is positive, indicating that the company will earn more than the required 10% return on the investment. Therefore, the project is justified and it is a good investment decision.

This analysis demonstrates the importance of considering time value of money when evaluating long-term investments. Even though the company faces an initial outflow of £30,000, the returns in future years, discounted at the required rate, ensure that the project provides value in excess of the company’s required return. 

Pooja Mattapalli