2. The key is to recognize that in a highly competitive industry, companies earn
zero NPV from their projects. Therefore, the question is simply asking for the PV- based break-even price of the utility meter. If we set that equal to y, annual cash flow is equal to 500,000×(y-5). Let’s then figure out the break-even annual cash flow by setting NPV equal to zero.
NPV=C0 + C1/r = -50 million + C1/0.1 = 0 C1 = 5 million
Let’s then solve for y by setting up the following equation:
500,000×(y-5) = 5 million y = 15.
10. The key is to find out what the selling price will be after the patent runs out in five year
First, consider the sequence of events:
At t = 0, the investment of $25,000,000 is made. At the end of the 1st year, i.e., t = 1, production begins, so the first revenue and expenses is recorded at the end of the 2nd year, t = 2. At the end of the 5th year, t = 5, the patent expires and competition enters. Since it takes one year to build the facility and start production, smart competitors will begin construction of their facility at t=4 so that they can start production as soon as the patent runs out at t=5. As a result, starting from t = 6, full competition will exist and thus any new entrant into the market for BGs will earn the 9% cost of capital, i.e., a zero NPV. Next, calculate the cash flows: At t = 0: –$25,000,000 At t = 1: $0 At t = 2, 3, 4, 5: Sale of 200,000 units at $100 each, with costs of $65 each, annual cash flow = $7,000,000. Starting from t = 6, the break-even price will be in effect since the NPV of new investment must be zero. Hence, to find the selling price per unit (P) solve the following for P: CF CF NPV = − 25,000,000 + 2 +L + = 0, where CF = 200,000 × (P − 65). 1.09 1.0912 It is more convenient to first solve for CF and then P. To solve for CF, CF CF NPV = −25,000,000 + 2 +L + 1.09 1.09 12 1 CF CF = −25,000,000 + ×( +L + ) 1.09 1.09 1.09 11 1 = −25,000,000 + × PV (11 - year annuity) 1.09 1 1 1 1 = −25,000,000 + × CF × ( − × ) 1.09 0.09 0.09 1.0911 =0 CF = 4,000,000 Since CF=200,000×(P-65), P=85. So for years t = 6 through t = 12, the annual cash flow will be: [200,000 × ($85 - $65)] = $4,000,000. Finally, the net present value (in millions): 7 7 4 4 NPV = − 25 + 2 + L + + 6 + L + 1.09 1.09 5 1.09 1.0912 1 = −25 + × PV (4 - year annuity of 7 million per year) 1.09 1 + × PV (7 - year annuity of 4 million per year) 1.095 1 1 = -25 + × 22.6780 + × 20.1318 1.09 1.095 = 8.89 million
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