Question

You are asked to check the feasibility of software development project. The initial development cost is $10M and the project will require an annual maintenance by the team of engineers and product managers. The annual salary of the team member is $150K. In year 1, the project will require 5 team members and in years 2-4 it will require 10 team members. The subscription revenues start in year 2 and end in year 4 (3 years). The average client pays $2,000 per year and the company is expected to have 3,000 clients for each year. Assume that the cost of capital is 10%.

Determine the cash flow from the project in each year (0-4).

Calculate the project’s NPV and IRR. Will you undertake the project?

Calculate the project’s NPV if the cost of capital declines to 7%. Will you still undertake the project?

Answer 1

Since 1 million is equal to 1000K, we have converted all cash flows into millions to evaluate this project.

Cash flows for the project are as follows:

Year 0- Ouflow=Initial development cost=$10 million which is also net outflow.

Year 1:

Outflow=Annual maintenance(5 team members)=(5*150)/1,000=$0.75 million

Inflow=none

Net outflow=$0.75 million

Years 2-4:

Outflow in each year=Annual maintenance(10 team members)=(10*150)/1,000=$1.5 million

Inflow in each year=subscription revenue=number of clients*payment by each client=(2,000/1,000*3,000/1,000)=$6 million

Net inflow in each year=6-1.5=$4.5 million

NPV and IRR:

1	2	3	4=2-3	5	6=4*5
Year	Inflow	Outflow	Net Flow	DF @ 10%	PV
0	0	10	-10	1.0000	-10
1	0	0.75	-0.75	0.9091	-0.6818
2	6	1.5	4.5	0.8264	3.7190
3	6	1.5	4.5	0.7513	3.3809
4	6	1.5	4.5	0.6830	3.0736
				NPV	-0.5083
				IRR	-4%

Project cannot be undertaken since NPV and IRR are negative.

Note: To calculate DF that is dsicounting factor, formula used is power(1/1.1,years)

If cost of capital declines to 7%:

1	2	3	4=2-3	5	6=4*5
Year	Inflow	Outflow	Net Flow	DF @ 7%	PV
0	0	10	-10	1.0000	-10
1	0	0.75	-0.75	0.9346	-0.7009
2	6	1.5	4.5	0.8734	3.9305
3	6	1.5	4.5	0.8163	3.6733
4	6	1.5	4.5	0.7629	3.4330
				NPV	0.3359

The project can now be accepted since NPV is postive.