Net Present Value

ACE Company

A CE Company is the technology and market leader in the portable
electronic games industry. The company is currently enjoying great
success with its Model X, which has been on the market for several
years. ACE's management believes that because of increased competition
from other types of entertainment, the demand for Model X will dry up
after three more years. The company has forecast Model X's net cash
inflows in the next three years to be $400 million, $300 million, and
$200 million, respectively.

New Product Development

ACE's senior managers are considering the development and introduction
of a replacement for Model X, to be called Model Z. According to the
engineers, ACE already possesses the technical expertise to develop
Model Z. However, the earliest that this product can be introduced into
the-market is one year from now, as it will take this long to develop
and test the new product, coordinate with suppliers for parts, set up
the production process, and arrange for other related logistic
activities. The total cost of these development activities is estimated
at $550 million.

All of ACE's top managers agree that Model Z's market potential in terms
of net cash inflow would be $200 million in year 2, $400 million in year
3, $300 million in year 4, and $100 million in year 5. They also agree
that Model Z would maintain ACE's leadership position in the portable
electronic games industry.

Management expects that in addition to developing its own customer base,
Model Z also would draw some sales away from Model X. The expected
amount of this "cannibalization" is $100 million of net cash inflows per
year. The following table summarizes ACE's prediction of net cash flows
(in millions) for the next five years for Model X by itself and with the
introduction of Model Z at the end of year 1 (or, equivalently stated,
the beginning of year 2). For simplicity, cash outflows are assumed to
occur at the beginning of the year while cash inflows are assumed to
occur at year end. Thus, for example, the $550 million development cost
in year 1 is assumed to occur at time zero, while the net cash inflow
from introducing Model Z at the beginning of year 2 is assumed to occur
at the end of that year. Also note that in the table, net cash inflows
of $100 million per year are shifted from Model X to Model Z in years 2
and 3.

Model X Introduce Model Z After One Year

Year Only Model X + Model Z = Total

0 $ 0 $ 0 + $ (550) = $(550)

1 $400 $400 + 0 = $ 400

2 $300 $ 200* + 300* = $ 500

3 $200 $ 100* + $ 500* = $ 600

4 $ 0 $0 + $ 300 = $ 300

5 $ 0 $0 + $ 100 = $ 100

* Reflects $100 cannibalization of Model X by Model Z.

Extending the Development Period for Product Z

Several members of top management are concerned about Model Z's erosion
of Model X sales. They propose that it would be better to spread the
development of Model Z over two years and to introduce it at the
beginning of year 3 instead of year 2. They suggest that this plan has
two major advantages: (1) it would avoid the $100 million erosion in
Model X's net cash inflows in year 2; and (2) the engineers have
projected that extending the time for the development process will yield
substantial savings due to efficiencies in scheduling. They have
estimated that the two-year plan would reduce Model Z's total
development cost to $300 million. Half of this total would be spent in
each of the two years.

The table below summarizes the estimated net cash flows (in millions)
for the two-year plan. Compared to the one-year plan, Model X's year 2
net cash inflow is higher by $100 million. This is due to avoiding
cannibalization by Model Z in year 2.

Model X Introduce Model Z After One Year

Year Only Model X + Model Z = Total

0 $ 0 $ 0 + $ (150) = $(150)

1 $400 $ 400 + $(150) = $ 250

2 $300 $ 300 + 0 = $ 300

3 $200 $ 100* + $ 500* = $ 600

4 $ 0 $0 + $ 300 = $ 300

5 $ 0 $0 + $ 100 = $ 100

* Reflects $100 cannibalization of Model X by Model Z.

Proponents of the two-year plan acknowledge that delaying Model Z's
introduction by one year would require foregoing its year 2 $300 million
net cash inflow. But they emphasize that this sacrifice is more than
made up by the additional $100 million cash inflow from Model X in year
2 and the $250 million savings in Model Z development costs.

Other Considerations

Supporters of the one-year plan argue that proponents of the two-year
plan have overlooked a major factor: that the timing of Model Z's
introduction could have an impact on competitors' actions. They maintain
that if ACE does not introduce Model Z as quickly as possible, ACE's
major competitor would most certainly come in with a comparable product.
In response to a query from these managers, ACE's engineers have
conducted a study of the competitor's current capabilities, They have
reported that due to the competitor's less sophisticated technologies,
it will require two years to develop a comparable product for market
introduction.

The nature of the industry is such that there is a significant
first-mover advantage. Similar products that reach the market at the
same time tend to get equal shares of the market. But once a product is
introduced, it tends to get so entrenched that comparable products
introduced subsequently can gain only inconsequential market shares.