Question

IT Software Project 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 $100,000 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 $450,000. 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 $65,000 to rent for the first year (same cost for the remaining years). You expect that the project will need to hire 3 new software specialists at $50,000 (each specialist) per year (start in year 1) for the full five years to work on the software (same cost for the remaining years). The project will use a van currently owned by the company. Although the van is not currently being used by the company, it can be rented out for $15,000 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 during the life of the project (5 years), with the first year expecting to be $250,000. The produced software is expected to sell at $85 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 25% 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 10.5%.

Based on the information presented above, answer the following questions

1. In evaluating the new IT software project, are the cost of $100,000 spent on marketing analysis? Explain your answer(s).

2. Calculate the incremental free cash flow during the project’s life (starting from year 0 to year 5). Show workings.

 

Answer 1

Sollution:-1) In evaluating the new IT software project, are the cost of $100,000 spent on marketing analysis.

In evaluating the new IT software project,

Given that the company has just paid a consulting firm $1,00,000 for a test marketing analysis, $1,00,000 had already been spent ,so nothing can be done about it now, or in future. So.it is not a relevant cost ,concerning this analysis.

Regarding the use of van,

Given that "although the van is not currently being used by the company, it can be rented out for $15,000 per year for five years"

so, that $ 15,000 rental income will be lost to the company, if the van is used in this project.

so, $15,000 /year becomes a relevant cost for this project--ie. Opportunity cost of rental income lost .

But the book value or salvage value of the van are not relevant for this analysis.

Also,as the depreciation is being claimed already, the company is not going to have any incremental cash flow(tax saving due to depreciation), on this account. So, depreciation of the van is also not relevant.

Sollution:-2)Calculation of the incremental free cash flow during the project’s life.

Year	,       0	1	2	3	4	5
1.Cost of computer hardware	(450,000)
2.NWC introd. & recovered	(50,000)					50,000
Incl.Operating cash flows:
3.Units sold		10,000	12,500	15,625	19,531	24,414
4.Sales $ at $85/unit(3*$85)		850,000	1,062,500	1,328,125	1,660,135	2,075,190
5.Cost at $40 /unit(3*$ 40)		(400,000)	(500,000)	(625,000)	(781,240)	(976,560)
6.Office rent		(65,000)	(65,000)	(65,000)	(65,000)	(65,000)
7.Software specialists'salary(50000*3)		(150,000)	(150,000)	(150,000)	(150,000)	(150,000)
8.Opportunity cost of rental income lost on van		(15,000)	(15,000)	(15,000)	(15,000)	(15,000)
9.Depreciation		(90,000)	(90,000)	(90,000)	(90,000)	(90,000)
10.Expected annual marketing and selling costs		(250,000)	(250,000)	(250,000)	(250,000)	(250,000)
11.EBT(sum 4 to 10)		(120,000)	(7,500)	133,125	308,895	528,630
12.Tax at 30%(11*30%)		-	-	(39,938)	(92,669)	(158,589)
13.EAT(11-12)		(120,000)	(7,500)	93,187	216,226	370,041
14.Add back:Depn.(same row 9)		90,000	90,000	90,000	90,000	90,000
15.Incl.Opg. Cash flow(13+14)		(30,000)	(82,500)	183,187	306,226	460,041
16.Net annual FCFs(1+2+15) (ANSWER:2)	(500,000)	(30,000)	(82,500)	183,187	306,226	465,041