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HW Sol 9 - Finance 6301 Corporate Finance Solution Set 6...

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University of Texas at Dallas School of Management Finance 6301 Professor Day Corporate Finance Fall 2010 Solution Set 6 1. The MacGregor Whiskey Company is evaluating a proposal to distill and manufacture diet scotch. Before investing in full-scale production of the new product, diet scotch will first be test-marketed for 2 years in Maine at an immediate up-front cost of $500,000 . Test-marketing the product is not expected to produce any profits but will reveal the strength of consumer preferences for diet scotch. There is a 60 percent chance that demand will be satisfactory, in which case MacGregor will spend $5 million to launch national distribution of the diet scotch, which would be generate expected yearly profits of $700,000 in perpetuity. If demand is not satisfactory, the distillation and production of diet scotch will be terminated immediately. Once consumer preferences are known, the risk of the product cash flows will be similar to the average risk level for MacGregor’s existing products, which have a required return of 12 percent. However, MacGregor’s CFO is convinced that the initial test-market phase is much riskier than normal. Assuming the MacGregor demands a return of 40 percent on the test-marking phase of new products, determine the NPV of decision to test market diet scotch? Assuming the test market phase is successful (proving that consumers will buy Diet Scotch), the expected cash flows (in years 2 through 5 ) from launching the diet scotch nationwide are Conditional Expected Cash Flows ( 1000s ) 0 1 2 3 4 5 Cash Flows <5000> 700 700 700 The test market phase of the project resolves uncertainty due to the new product introduction. Thus, the (conditional) expected cash flows should be discounted at the firm's normal 12 percent opportunity cost of capital. So the date 2 NPV of the project (given a successful test market) is NPV 2 = <$5000> + $700 0.12 , = $833.33 . If test marketing shows that whisky drinkers don't care about saving calories by drinking diet scotch, the project will be abandoned and the NPV of the future cash flows will be zero. Thus, the end of year two expected payoff of test marketing the product is $500 (.60 x $833.33 + .40 x 0 ), where the probability of a successful test market phase (NPV of $833.33 ) is 0.60 and the probability that consumers will choose not to purchase the new product is 0.40 . The date 0 NPV of the decision to test market the product should be determined using a supernormal discount rate (say 40 percent). Thus, the date zero NPV for the project would be, NPV 0 = <$500> + $500 (1.40) 2 , = <$244.90> . However, in this example the particular discount used to determine the date zero NPV for the project is irrelevant. Since the expected NPV for the project at date 2 is exactly equal to the required date 0 investment in the test market phase of the project, the NPV for this particular project must be negative for any positive discount rate. Therefore, the project should be rejected.
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2 2. The stock of Koninklijke Phillips Electronics NV (PHG) is currently trading at a market price of $50 per share. During the next year, the price of PHG’s stock will either increase (uptick)
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