Question

KADS, Inc. has spent RM300,000 on research to develop a new computer game. The firm is planning to spend RM250,000 on a machine to produce the new game.

Shipping and installation costs of the machine will be capitalized and depreciated; they total RM50,000.

The machine has an expected life of 3 years, a RM175,000 estimated resale value, and depreciation is estimated at RM35,725 for 1st year, RM61,225 for 2nd year and RM43,725 for 3rd year.

Revenue from the new game is expected to be RM500,000 per year, with costs of RM250,000 per year.

It is expected that the machine needs a major maintenance in second year of operation at a cost of RM200,000.

The firm has a tax rate of 35 percent, an opportunity cost of capital of 15 percent, and it expects net working capital (in term of advance payment for machine licence) to increase by RM100,000 at the beginning of the project and will be fully recaptured at the end of the project.
What will the cash flows for this project be? Should KADS undertake this project? Why?

Answer 1

Year	0	1	2	3
Revenue		500000.00	500000.00	500000.00
Less: Costs		250000.00	250000.00	250000.00
Less: maintenance			200000.00
Less: Depreciation		35725.00	61225.00	43725.00
PBT		214275.00	-11225.00	206275.00
Tax @ 35%		74996.25	-3928.75	72196.25
PAT		139278.75	-7296.25	134078.75
Add: depreciation		35725.00	61225.00	43725.00
Less: costs of machine	250000
Less: shipping and installation	50000
Add: resale value				175000
Less: taxes @ 35%				5486.25
Less: working capital	100000			-100000
Net Cash Flow	-400000	175003.75	53928.75	447317.5
NPV @ 15%	87,073.57
Resale	175000
Book value
Investment	400000
Less: depreciation	140675
Book value	259325
Tax @ 35%	-29513.75
Since NPV is positive the project should be undertaken. Also the R&D costs is ignored as it is a sunk cost