Question

Innovation Company is thinking about marketing a new software product. Upfront costs to market and develop the product are $5,300,000.

The product is expected to generate profits of $1,200,000

per year for ten years. The company will have to provide product support expected to cost $92,000

per year in perpetuity. Assume all income and expenses occur at the end of each year.

a. What is the NPV of this investment if the cost of capital is 5.51%??

Should the firm undertake the? project? Repeat the analysis for discount rates of 1.60%

and 15.60%?, respectively.

b. How many IRRs does this investment opportunity? have? ? (Hint: Consider the two alternative discount rates we used in our analysis in part? a.)??

c. Can the IRR rule be used to evaluate this? investment? Explain.

Answer 1

a. 1.   Present value of cash inflow = 1200000 * PVAF (5.51%,10years)

= 1200000 * 7.5340

= 9040800

Present value of perpetuity of cost = $92000 / 5.51%

=1669691

NPV = present value of cash inflow - present value of cash outflow

= 9040800 - [1669691 + 5300000]

= 9040800 - 6969691

= 2071109

The project should be undertaken ,because it has positive NPV.

2. analysis for discount rates of 1.60% ,

NPV = present value of cash inflow - present value of cash outflow

= [1200000 * 9.1735] - [(92000 / 0.016) + 5300000]

= [1200000 * 9.1735] - 11050000

= 11008200 - 11050000

= (41800)

The project should not be undertaken ,because it has negative NPV.

3. analysis for discount rates of 15.60% ,

NPV = present value of cash inflow - present value of cash outflow

= [1200000 * 4.9061] - [(92000 / 0.156) + 5300000]

= 5887320 - 5889744

= (2424)

The project should not be undertaken ,because it has negative NPV.

b. Two IRR s , because of two IRR, one of the discouting rate will result the NPV to zero. On the basis of second IRR rate, decision will be made according to it.

c. No , if there is more than one IRR ,then the rule of IRR will not be appilcable.