Question

Innovation Company is thinking about marketing a new software product. Upfront costs to market and develop the product are $ 4.94 million. The product is expected to generate profits of $ 1.18 million per year for ten years. The company will have to provide product support expected to cost $ 96000 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 6.2 %​? Should the firm undertake the​ project? Repeat the analysis for discount rates of 1.1 % and 17.5 %​, respectively.

b. What is the IRR of this investment​ opportunity?  

c. What does the IRR rule indicate about this​ investment?

Answer 1

Ans. Initial investment (in year 0) = $4.94 million

Revenue each year = $1.18 million

Cost each year = $0.096 million

Perpetual cash flows from year 1 till infinity = Revenue - Cost

=> CF = 1.18 million - 0.096 million = 1.084 million

a) For NPV (in $ million) at Cost of capital = i

NPV = - 4.94 + 1.084/(1+i) + 1.084/(1+i)2 +.....till infini

NPV = - 4.94 + 1.084/i

(From sum of infinite geometric progression formula)

When i = 0.062 or 6.2 %

NPV = -4.94 + 1.084/0.062 = $12.544million

As NPV is positive, the firm should undertake this project

Similarly,

When i = 1.1% or 0.011

NPV = $93.6 million

As NPV is positive,so, firm should undertake this project.

When i = 17.6% or 0.176

NPV = $1.22 million

As NPV is positive, so, firm should undertake this project.

b) For IRR,

NPV = 0 at IRR

=> NPV = 0 = -4.94 + 1.084/IRR

=> IRR = 0.2194 or 21.94%

c) IRR rules indicates that the investment should be undertaken by the firm if the cost of capital is less than 21.94% (The internal rate of return) i.e. if the return on the investment than the cost undertaken for the project.

*Please don’t forget to hit the thumbs up button, if you find the answer helpful.