Question

Answer the following questions:

(a) Tencent Games is a video game publishing company fully owned by the Chinese internet giant, Tencent. It is now evaluating the potential of a new game launch.

The project will cost $900,000, have a 6-year life with no salvage value, depreciation is straight-line to zero. Sales are projected at 6,000 customers per year, and price per game is $20, the variable cost per customer will be $10, and fixed costs will be $250,000. The required return on the project is 15%, and the relevant tax rate is 30%. Calculate the project's IRR, and NPV. Recommend if the project should go ahead.

(b) The Tencent games has a new video game production project available to it at a cost of $6,000,000. If the project is accepted, the company will be able to sell

13,000 games at $172 in net cash flow for each of the next five years. The company's discount rate is 15%. What is the NPV of the investment? The executives of the Tencent games are concerned about the potential of future competition and a subsequent drop in sales and price. If after two years you can dispose of the asset for $1,000,000 at what price would it make sense to abandon the project?

(c) Given the goal of maximization of firm value and shareholder wealth, we have stressed the importance of net present value (NPV). However, many financial decision-makers at some of the most prominent firms in the world continue to use a group of measures such as the payback period, IRR, profitability index and NPV. Why do you think this is the case? Explain the merit and shortcoming of each rule.

(d) Why is straight NPV analysis flawed as compared to models that include option pricing in the NPV analysis?

Answer 1

a.
Year	0	1
Initial cost	-900000
Operating cash flows:
Sales(6000*20)		120000
Variable cost(6000*10)		-60000
Fixed costs		-250000
Depn.(900000/6)		-150000
EBT		-340000
Tax at 30%		102000
EAT		-238000
Add back:depn.		150000
OCF		-88000
NO
The project should not go ahead
as it has negative net cash flows of 88000 in each of the 6 years
hence NPV is negative & IRR may not be discernible with all -ve cash flows

b.NPV (video games)=-6000000+(13000*172*(1-30%)*3.35216)+(360000*3.35216)=
453578.43
P/A i=15%,n=5 yrs.=(1-1.15^-5)/0.15= 3.35216
Depn. Tax shield for each of the 5 yrs.= 6000000/5=1200000*30%= 360000
Price To abandon the project at end of yr.2
-6000000+(13000*172*(1-30%)*1.62571)+(360000*1.62571)+(1780000/1.15^5)=
-1985209
ie. $ 1985210

Workings for b.
Cost	6000000
Acc. Depn.(6000000/5*2)	2400000
Carrying value	3600000
Sale value	1000000
Loss on sale	2600000
Tax saved on loss at 30%	780000
ATCF on sale	1780000

c.NPV attaches time value to all the cash flows , in entirety for a project.

cash flows are discounted at the cost of capital acquired to finance the project & hence the net present value , gives us a clearer picture of the feasibility of the project.

whereas,

IRR does not consider cash flows beyond the IRR achieved & the results are not reliable , if there are mutiple negative cash flows ,leading to multiple IRR.

Profiatbility index depends entirely on the NPV & hence as good as NPV

Payback period , just conveys when the initial investment is recouped & does not bother about cash flows after that.

d. That is because a normal NPV analysis formula does not include various real options that exist in the investment.For example an investment might not be generating cash flows in the beginning ,but has the option to expand after some years--with some determinable probabilities.

Hence the straight NPV analysis is said to be lacking , in analysing value of real options.