Innovation Company is thinking about marketing a new software product. Upfront c
ID: 2819394 • Letter: I
Question
Innovation Company is thinking about marketing a new software product. Upfront costs to market and develop the product are $5,200,000. The product is expected to generate profits of $1,300,000 per year for ten years. The company will have to provide product support expected to cost $93,000 per year in perpetuity. Assume all income and expenses occur at the end of each year.
a. What is the NPV of this investment if the cost of capital is 5.17% Should the firm undertake the project? Repeat the analysis for discount rates of 1.34% and 18.72% respectively.
b. How many IRRs does this investment opportunity have? (Hint: Consider the two alternative discount rates we used in our analysis in part a.)
c. Can the IRR rule be used to evaluate this investment? Explain.
Explanation / Answer
Answer a.
Year
Upfront cost (1)
Profit (2)
Cost (3)
Total cashflow (4)=(1+2+3)
Dis factor @5.17% (5)
Dis factor @1.34% (6)
Dis factor @18.72% (7)
Dis cashflow @5.17% (4*5)
Dis cashflow @1.34% (4*6)
Dis cashflow @18.72% (4*7)
0
-5200000
-5200000
1
1
1
- 5,200,000
- 5,200,000
- 5,200,000
1
1300000
-93000
1207000
0.950841
0.986777
0.842318
1,147,666
1,191,040
1,016,678
2
1300000
-93000
1207000
0.9041
0.973729
0.7095
1,091,248
1,175,291
856,366
3
1300000
-93000
1207000
0.859655
0.960854
0.597624
1,037,604
1,159,751
721,333
4
1300000
-93000
1207000
0.817396
0.948149
0.50339
986,597
1,144,415
607,592
5
1300000
-93000
1207000
0.777214
0.935611
0.424014
938,097
1,129,283
511,785
6
1300000
-93000
1207000
0.739007
0.92324
0.357155
891,982
1,114,351
431,086
7
1300000
-93000
1207000
0.702679
0.911032
0.300838
848,133
1,099,616
363,112
8
1300000
-93000
1207000
0.668136
0.898986
0.253401
806,440
1,085,076
305,855
9
1300000
-93000
1207000
0.635292
0.887099
0.213445
766,797
1,070,728
257,628
10
1300000
-93000
1207000
0.604062
0.875369
0.179788
729,102
1,056,570
217,004
Total
4,043,667
6,026,120
88,438
NPV
4,043,667
6,026,120
88,438
Firm should undertake the project in case of all the three dis factor since NPV is positive.
Answer B
There is only one IRR 19%.
Year
Upfront cost (1)
Profit (2)
Cost (3)
Total cashflow (4)=(1+2+3)
0
-5200000
-5200000
1
1300000
-93000
1207000
2
1300000
-93000
1207000
3
1300000
-93000
1207000
4
1300000
-93000
1207000
5
1300000
-93000
1207000
6
1300000
-93000
1207000
7
1300000
-93000
1207000
8
1300000
-93000
1207000
9
1300000
-93000
1207000
10
1300000
-93000
1207000
IRR
19%
IRR(L20:L30)
If the IIR is higher than the discount rate the project is good to pursue. IRR 19% is higher than all the three discount rates. Hence it should be executed.
Year
Upfront cost (1)
Profit (2)
Cost (3)
Total cashflow (4)=(1+2+3)
Dis factor @5.17% (5)
Dis factor @1.34% (6)
Dis factor @18.72% (7)
Dis cashflow @5.17% (4*5)
Dis cashflow @1.34% (4*6)
Dis cashflow @18.72% (4*7)
0
-5200000
-5200000
1
1
1
- 5,200,000
- 5,200,000
- 5,200,000
1
1300000
-93000
1207000
0.950841
0.986777
0.842318
1,147,666
1,191,040
1,016,678
2
1300000
-93000
1207000
0.9041
0.973729
0.7095
1,091,248
1,175,291
856,366
3
1300000
-93000
1207000
0.859655
0.960854
0.597624
1,037,604
1,159,751
721,333
4
1300000
-93000
1207000
0.817396
0.948149
0.50339
986,597
1,144,415
607,592
5
1300000
-93000
1207000
0.777214
0.935611
0.424014
938,097
1,129,283
511,785
6
1300000
-93000
1207000
0.739007
0.92324
0.357155
891,982
1,114,351
431,086
7
1300000
-93000
1207000
0.702679
0.911032
0.300838
848,133
1,099,616
363,112
8
1300000
-93000
1207000
0.668136
0.898986
0.253401
806,440
1,085,076
305,855
9
1300000
-93000
1207000
0.635292
0.887099
0.213445
766,797
1,070,728
257,628
10
1300000
-93000
1207000
0.604062
0.875369
0.179788
729,102
1,056,570
217,004
Total
4,043,667
6,026,120
88,438
NPV
4,043,667
6,026,120
88,438