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 $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 (inclusive inflation). 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 $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

In capital budgeting decisions, opportunity cost should be considered as it reduces the cash flow same as any other cost. Same is the case with cost incurred on marketing analysis and that is a one time fixed cost for the project that has to be recovered over the course of the project life cycle. Hence, In evaluating the new IT software project, are the cost of $50,000 spent on marketing analysis and the use of van which is more like an opportunity cit must be considered for capital budgeting decisions.

For the calculations, I have considered 1.5% as the inflation rate in Australia.

Inflation	1.50%
	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Selling price per unit (Inflation adjusted)		100	102	103	105	106
No. of units sold		10,000	12,000	14,400	17,280	20,736
Revenue		1,000,000	1,218,000	1,483,524	1,806,932	2,200,843
Cost of production price per unit (inflation adjusted)		40	41	41	42	42
COGS		400,000	487,200	593,410	722,773	880,337
Gross Profit		600,000	730,800	890,114	1,084,159	1,320,506
	Marketing and selling costs		200000
	Marketing and selling costs (% of revenue)		20%	20%	20%	20%	20%
Total Marketing and selling costs		200,000.0	243,600.0	296,704.8	361,386.4	440,168.7
General and admin
Rent		80,000.0	81,200.0	82,418.0	83,654.3	84,909.1
Software specialists		150,000.0	152,250.0	154,533.8	156,851.8	159,204.5
Van opportunity cost		5,000.0	5,000.0	5,000.0	5,000.0	5,000.0
Depreciation
Van		4,000.0	4,000.0	4,000.0	4,000.0	4,000.0
Computer hardware		80,000.0	80,000.0	80,000.0	80,000.0	80,000.0
Total expenses		519,000.0	566,050.0	622,656.6	690,892.5	773,282.3
Earning before tax		81,000.0	164,750.0	267,457.9	393,266.9	547,223.8
Taxes (30%)		24,300.0	49,425.0	80,237.4	117,980.1	164,167.1
Net earnings		56,700.0	115,325.0	187,220.5	275,286.8	383,056.6
Add depreciation		84,000.0	84,000.0	84,000.0	84,000.0	84,000.0
Less Capex	(450,000.0)
Less working capital	(50,000.0)					50,000.0
FCFF	(500,000.0)	140,700.0	199,325.0	271,220.5	359,286.8	517,056.6
Terminal value						2,585,283.18
Total cash flow	(500,000.0)	140,700.0	199,325.0	271,220.5	359,286.8	3,102,339.8
Net cash flow	(500,000.0)	(359,300.0)	(159,975.0)	111,245.5	470,532.3	3,572,872.1
Discount rate	20%
NPV	$1,110,545.34
IRR	67%
Payback period	3	years

Since the project has positive IRR and the costs are recovered in 3 years, the project should be accepted.