The Jogger Shoe Company is trying to decide whether to make a change in its most popular brand of running shoes. The new style would cost the same to produce and be priced the same, but it would incorporate a new kind of lacing system that (according to its marketing research people) would make it more popular.
There is a fixed cost of $300,000 for changing over to the new style. The unit contribution to before-tax profit for either style is $8. The tax rate is 35%. Also, because the fixed cost can be depreciated and will therefore affect the after-tax cash flow, we need a depreciation method. We assume it is straight-line depreciation.
The current demand for these shoes is 190,000 pairs annually. The company assumes this demand will continue for the next 3 years if the current style is retained. However, there is uncertainty about demand for the new style, if it is introduced. The company models this uncertainty by assuming a normal distribution in year 1, with mean 220,000 and standard deviation 20,000. The company also assumes that this demand, whatever it is, will remain constant for the next 3 years. However, if demand in year 1 for the new style is sufficiently low, the company can always switch back to the current style and realize an annual demand of 190,000. The company wants a strategy that will maximize the expected NPV of total cash flow for the next 3 years, where a 15% interest rate is used for the purpose of calculating NPV.