a. Choco Plc, a chocolate manufacturer, is considering to introduce a new chocolate flavor. The success of the product depends on the state of the economy over the next 12 months. The state of the economy is very closely linked to the return on the FTSE 100 index, which is currently trading at 6,350. In 12 months, it will either go up to 7,580 or go down to 5,235 depending on whether the economy improves or deteriorates. 

These estimates assume that all dividends paid out to FTSE 100 companies' shareholders are reinvested in companies' shares. If the economy improves, the revenues from the project are estimated to be £6 million a year for 10 years, starting a year from now. On the other hand, 

if the economy deteriorates, the revenues are expected to be £2.5 million a year for 10 years starting a year from now. Risk-free rate is 5 percent per annum. Initial cost of the project is £25 million. 

Required: Calculate the NPV of the project. 

b Choco's CEO thinks that the project is too risky and wants to wait for a year and only invest in the project if the economy improves. Assume that if the decision is delayed the project cash flows and its time duration do not change, but the cash flows will start in 2 years' time. Also assume that Choco's competitors are not ready to produce the new flavor within the next 12 months. (10 marks) 

Required: 

Calculate the NPV of the project if the CEO's proposal is accepted. Calculate the value of the option to delay the project. 

c  Now assume that other chocolate manufacturers can enter the market within the next 12 months and if they do, the estimated revenues from the project will no longer be valid. However, Choco Plc can obtain a patent for its new flavour in which case no other chocolate manufacturer will be able to enter the new flavour market within the next 12 months. The cost of this patent is £1million. 

Required: 

Explain whether the company should buy the patent.

Answer rating: 100% (QA)

a Calculate the NPV of the project Assuming the economy improves NPV 25 6105 61052 610510 25 61 1105 ... View the full answer