Innovation Company is thinking about marketing a new software product. Upfront c
ID: 2791392 • Letter: I
Question
Innovation Company is thinking about marketing a new software product. Upfront costs to market and develop the product are $4.93 million. The product is expected to generate profits of $1.07 million per year for ten years. The company will have to provide product support expected to cost $90,000 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 5.7%? Should the firm undertake the project? Repeat the analysis for discount rates of 1.4% and 14.5%, respectively.
b. What is the IRR of this investment opportunity?
c. What does the IRR rule indicate about this investment?
Explanation / Answer
a) PV of profits of 10 years = 1.07*(1.057^10-1)/(0.057*1.057^10) = $ 7.99 million PV of product support cost (perpetuity) = 0.09/0.057 = $ 1.58 million Upfront marketing and development costs $ 4.93 million NPV = 7.99-1.58-4.93 = $ 1.48 million As the NPV is positive, the project can be undertaken. Discount rate of 1.4%: PV of profits of 10 years = 1.07*(1.014^10-1)/(0.014*1.014^10) = $ 9.92 million PV of product support cost (perpetuity) = 0.09/0.014 = $ 6.43 million Upfront marketing and development costs $ 4.93 million NPV = 9.92-6.43-4.93 = $ (1.44) million As the NPV is negative, the project should not be undertaken. Discount rate of 14.5%: PV of profits of 10 years = 1.07*(1.145^10-1)/(0.145*1.145^10) = $ 5.47 million PV of product support cost (perpetuity) = 0.09/0.145 = $ 0.62 million Upfront marketing and development costs $ 4.93 million NPV = 5.47-0.62-4.93 = $ (0.08) million As the NPV is negative, the project should not be undertaken. b) IRR is that discount rate for which the NPV = 0, or PV of cash inflows = PV of cash outflows. 4.93+0.09/r = 1.07*PVIFA(r,10) The value of r (IRR) is to be found by trial and error, For r=14.5% NPV = -0.08 (as worked out above) For r=14%, NPV = PV of profits of 10 years = 1.07*(1.14^10-1)/(0.14*1.14^10) = $ 5.58 million PV of product support cost (perpetuity) = 0.09/0.14 = $ 0.64 million Upfront marketing and development costs $ 4.93 million NPV = 5.47-0.62-4.93 = 0.01 $ 0.01 million IRR = 14+0.5*0.01/(0.01+0.08) = 14.06% c) The project is acceptable only if the cost of capital is less than 14.06%; so it is acceptable if the cost of capital is 5.7% or 1.4%, not if it is 14.5%.