Question

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As a senior analyst for the company you have been asked to evaluate a new IT software project. The company has just paid a consulting firm $50,000 for a test marketing analysis. After looking at the project plan, you anticipate that the project will need to acquire computer hardware for a cost of $400,000. The Australian Taxation Office rules allow an effective life for the computer hardware of five years. The equipment can be depreciated on a straight-line (prime cost) basis and there is no expected salvage value after the five years.

Your company does not have any available space where the project can be located for five years and you anticipate a new office will cost $80,000 to rent for the first year. You expect that the project will need to hire 3 new software specialists at $50,000 (each specialist) in the first year for the full five years to work on the software.

The project will use a van currently owned by the company and although the van is not currently being used by the company, it can be rented out for $5,000 per year for five years. The book value of the van is $20,000. The van is being depreciated straight-line (with five years remaining for depreciation) and is expected to be worthless after the five years.

Expected annual marketing and selling costs will be incurred, with the first year expecting to be $200,000. The produced software is expected to sell at $100 per unit while the cost to produce each unit is $40. You expect that 10,000 units will be sold in the first year and the number of units sold will increase by 20% a year for the remaining four years. The project will need working capital of $50 000 to commence the business (in year 0) and the investment in working capital is to be completely recovered by the end of the project’s life (in year 5). The company tax rate is 30%, and the discount rate is 10%.

Based on the information presented above, answer the following questions (1) – (3).

1. In evaluating the new IT software project, are the cost of $50,000 spent on marketing analysis and the use of van relevant for capital budgeting decision? Explain your answer(s).

2. Calculate the incremental free cash flow during the project’s life (at the end of Years 1 through 5). Show workings.\

3. Calculate the NPV, payback period and IRR of the project. Should the project be accepted? Show workings and explain your answer(s).

Answer 1

1]	The amount of $50000 spent on marketing analysis is a sunk cost and hence is irrelevent for the current decision.
	The use of the van is relevant as far as the rent
	of $5000 that can be got if the van is not used for
	the project. The bookvalue of the van and its
	depreciation are irrelevant.
2]		0	1	2	3	4	5
	Sales in units		10000	12000	14400	17280	20736
	Sales revenue [$100/unit]		$    10,00,000	$       12,00,000	$      14,40,000	$ 17,28,000	$ 20,73,600
	-Cost of production [other than depn] - $40/unit		$      4,00,000	$          4,80,000	$        5,76,000	$   6,91,200	$     8,29,440
	-Depreciation [400000/5]		$          80,000	$             80,000	$            80,000	$       80,000	$        80,000
	-Office rent		$          80,000	$             80,000	$            80,000	$       80,000	$        80,000
	-Cost of software specialists [50000*3]		$      1,50,000	$          1,50,000	$        1,50,000	$   1,50,000	$     1,50,000
	-Rent income lost on use of truck		$            5,000	$                5,000	$              5,000	$         5,000	$           5,000
	-Marketing and selling costs		$      2,00,000	$          2,00,000	$        2,00,000	$   2,00,000	$     2,00,000
	NOI		$          85,000	$          2,05,000	$        3,49,000	$   5,21,800	$     7,29,160
	-Tax at 30%		$          25,500	$             61,500	$        1,04,700	$   1,56,540	$     2,18,748
	NOPAT		$          59,500	$          1,43,500	$        2,44,300	$   3,65,260	$     5,10,412
	Add: Depreciation		$          80,000	$             80,000	$            80,000	$       80,000	$        80,000
	OCF		$      1,39,500	$          2,23,500	$        3,24,300	$   4,45,260	$     5,90,412
	-Capital spending	$   4,00,000
	-Change in NWC	$       50,000					$       -50,000
	Incremental free cash flow	$ -4,50,000	$      1,39,500	$          2,23,500	$        3,24,300	$   4,45,260	$     6,40,412
3]	NPV:
	PVIF at 10% [PVIF = 1/1.10^t]	1	0.90909	0.82645	0.75131	0.68301	0.62092
			[1/1.1]	[1/1.1^2]	[1/1.1^3]	[1/1.1^4]	[1/1.1^5]
	PV at 10% [Incremental free cash flow*PVIF}	$ -4,50,000	$      1,26,818	$          1,84,711	$        2,43,651	$   3,04,119	$     3,97,645
	NPV [Sum of PV for 5 years]	$   8,06,944
	As the NPV is positive, the project can be undertaken as it will increase shareholders' wealth.
	Payback period:
	Cumulative free cash flow	$ -4,50,000	$    -3,10,500	$            -87,000	$        2,37,300	$   6,82,560	$ 13,22,972
	Payback period = 2+87000/324300 =	2.27	Years
	The payback period indicates that the initial investment will be recouped in 2.27 years.
	IRR:
	IRR is that discount rate for which the NPV will be 0. Such discount rate can be found out by trial and error by varying
	the discount rates to get 0 NPV.
	Discounting with 51%:							NPV
	PVIF at 51% [1/1.51^t]	1	0.66225	0.43858	0.29045	0.19235	0.12738
	PV at 51%	$ -4,50,000	$          92,384	$             98,022	$            94,192	$       85,646	$        81,578	$         1,823
	Discounting with 52%:
	PVIF at 52% [1/1.52^t]	1	0.65789	0.43283	0.28475	0.18734	0.12325
	PV at 52%	$ -4,50,000	$          91,776	$             96,736	$            92,346	$       83,414	$        78,930	$       -6,798
	IRR = 51%+1%*1823/(1823+6798) =	51.21%