Innovation Company is thinking about marketing a new software product. Upfront c
ID: 2790939 • Letter: I
Question
Innovation Company is thinking about marketing a new software product. Upfront costs to market and develop the product are
$ 4.93$4.93
million. The product is expected to generate profits of
$ 1.13$1.13
million per year for ten years. The company will have to provide product support expected to cost
$ 92 comma 000$92,000
per year in perpetuity. Assume all profits and expenses occur at the end of the year.
a. What is the NPV of this investment if the cost of capital is
5.6 %5.6%?
Should the firm undertake the project? Repeat the analysis for discount rates of
1.2 %1.2%
and
16.2 %16.2%,
respectively.
b. What is the IRR of this investment opportunity?
c. What does the IRR rule indicate about this investment?
Explanation / Answer
Interest Rate at 5.6%
We need to calculate the PV of three different components:
Upfront costs: -$4,930,000 is the PV at t = 0
Profits:
PMT = -1,130,000
N = 10
I = 5.6
PV = 8,951,511.51
Support:
PV at t = 10 = 92,000/ 0.056
PV = -1,642,857.14
PV at start = -4,930,000 + 8,951,511.51 - 1,642,857.14
PV at start = 2,378,654.37
Interest Rate at 1.2%
We need to calculate the PV of three different components:
Upfront costs: -$4,930,000 is the PV at t = 0
Profits:
PMT = -1,130,000
N = 10
I = 1.2
PV = 10,715,711.58
Support:
PV at t = 10 = 92,000/ 0.012
PV = -7,666,666.67
PV at start = -4,930,000 + 10,715,711.58 - 7,666,666.67
PV at start = -1,880,955.09
Interest Rate at 16.2%
We need to calculate the PV of three different components:
Upfront costs: -$4,930,000 is the PV at t = 0
Profits:
PMT = -1,130,000
N = 10
I = 16.2
PV = 6,299,348.02
Support:
PV at t = 10 = 92,000/ 0.162
PV = -567,901.23
PV at start = -4,930,000 + 6,299,348.02 - 567,901.23
PV at start = 801,446.79
Part B
This has two IRRs which you wouldn’t know unless you graphed the NPV profile. A good rule of thumb though is that If a project has cash outflows during its life or at the end of its life in addition to its initial cash outflow, the project is said to have an unconventional cash flow pattern. Projects with such cash flows may have more than one IRR (there may be more than one discount rate that will produce an NPV equal to zero).
Part c.
The IRR rule doesn’t apply when there are multiple IRR