The Wing Foot Shoe Company of Example 12.2 has refined its market study and has some additional information about potential customer acceptance of the new product. Management now feels that there are two possibilities along the upper branch. Consumer response can be good, or it may be excellent. The study indicates that if demand is good during the first year, there’s a 30% chance it will grow and be excellent in the second and third years. Of course, this also means there’s a 70% chance that demand in years 2 and 3 won’t change.
If consumer response to the product turns out to be excellent, an additional investment of $1 million in a factory expansion will allow the firm to make and sell enough product to generate cash inflows of $5 million rather than $3 million in both years 2 and 3. Hence, the net cash inflows for the project will be ($5 million – $1 million =) $4 million in year 2 and $5 million in year 3. (The expansion is necessary to achieve the better financial results because Example 12.2 stated that the factory was at capacity along the upper path.) A decision tree for the project with this additional possibility is as follows.
The Wing Foot Shoe Company is considering a three-year project to market a running shoe based on new technology. Success depends on how well consumers accept the new idea and demand the product. Demand can vary from great to terrible, but for planning purposes management has collapsed that variation into just two possibilities: good and poor. A market study indicates a 60% probability that demand will be good and a 40% chance that it will be poor.
It will cost $5 million to bring the new shoe to market. Cash flow estimates indicate inflows of $3 million per year for three years at full manufacturing capacity if demand is good, but just $1.5 million per year if it’s poor. Wing Foot’s cost of capital is 10%. Analyze the project and develop a rough probability distribution for NPV.