Question

Libby Flannery, the regional manager of Ecsy-Cola, the international soft drinks empire, was reviewing her investment plans for Central Asia. She had contemplated launching Ecsy-Cola in the ex-Soviet republic of Inglistan in 2019. This would involve a capital outlay of $20 million in 2018 to build a bottling plant and set up a distribution system there. Fixed costs (for manufactur-ing, distribution, and marketing) would then be $3 million per year from 2018 onward. This would be sufficient to make and sell 200 million liters per year—enough for every man, woman, and child in Inglistan to drink four bottles per week! But there would be few savings from building a smaller plant, and import tariffs and transport costs in the region would keep all production within national borders.The variable costs of production and distribution would be 12 cents per liter. Company policy requires a rate of return of 25% in nominal dollar terms, after local taxes but before deducting any costs of financing. The sales revenue is forecasted to be 35 cents per liter. Bottling plants last almost forever, and all unit costs and revenues were expected to remain constant in nominal terms. Tax would be payable at a rate of 30%, and under the Inglistan corpo-rate tax code, capital expenditures can be written off on a straight-line basis over four years.All these inputs were reasonably clear. But Ms. Flannery racked her brain trying to forecast sales. Ecsy-Cola found that the "1–2–4" rule works in most new markets. Sales typically double in the second year, double again in the third year, and after that remain roughly constant. Libby’s best guess was that, if she went ahead immediately, initial sales in Inglistan would be 12.5 million liters in 2020, ramping up to 50 million in 2022 and onward.Ms. Flannery also worried whether it would be better to wait a year. The soft drink market was developing rapidly in neighboring countries, and in a year’s time she should have a much better idea whether Ecsy-Cola would be likely to catch on in Inglistan. If it didn’t catch on and sales stalled below 20 million liters, a large investment probably would not be justified.Ms. Flannery had assumed that Ecsy-Cola’s keen rival, Sparky-Cola, would not also enter the market. But last week she received a shock when in the lobby of the Kapitaliste Hotel she bumped into her opposite number at Sparky-Cola. Sparky-Cola would face costs similar to Ecsy-Cola. How would Sparky-Cola respond if Ecsy-Cola entered the market? Would it decide to enter also? If so, how would that affect the profitability of Ecsy-Cola’s project?Ms. Flannery thought again about postponing investment for a year. Suppose Sparky-Cola were interested in the Inglistan market. Would that favor delay or immediate action?Maybe Ecsy-Cola should announce its plans before Sparky-Cola had a chance to develop its own proposals. It seemed that the Inglistan project was becoming more complicated by the day.

a) Calculate the NPV of the proposed investment, using the inputs suggested in this case. How sensitive is this NPV to future sales volume?
b) What are the pros and cons of waiting for a year before deciding whether to invest? (Hint: What happens if demand turns out high and Sparky-Cola also invests? What if Ecsy-Cola invests right away and gains a one-year head start on Sparky-Cola?)

Answer 1

The NPV of Ecsy-Cola's proposed investment can be calculated using sales forecasts, costs, required rate of return, and tax considerations. It is sensitive to changes in future sales volumes. Pros of waiting include reduced uncertainty, while cons include the risk of losing market share to competitors.

Step-by-step explanation:

Net Present Value (NPV) Calculation and Sensitivity Analysis

To calculate the NPV of the proposed investment, we follow these steps:

Calculate the initial outlay, which is a $20 million investment in 2018.

Forecast sales volumes using the "1–2–4" rule with 12.5 million liters in the first year (2020) and doubling in subsequent years.

Calculate the revenue (35 cents per liter), variable costs (12 cents per liter), and fixed costs ($3 million annually).

Consider the tax rate of 30% on profits and account for the straight-line depreciation of the capital expenditure over four years.

Discount the net cash flows to their present value using the company's required rate of return of 25%.

The NPV is highly sensitive to future sales volume, as any deviation from the expected sales volumes could significantly affect profitability.

Pros and Cons of Waiting to Invest

Pros: More information about the market and potential competition from Sparky-Cola could be obtained, reducing uncertainty.

Cons: Potential loss of first-mover advantage and market share if Sparky-Cola decides to enter the market first.

Barriers to Entry and Economies of Scale

In some industries, such as the cola industry, large advertising budgets and established brand names act as significant barriers to entry for new competitors. Additionally, economies of scale can play a crucial role in production costs reduction, favoring larger production volumes.