Question

Capital Investment Analysis:

You have been tasked by the management team of the Cotton On Group to evaluate the desirability of the development and launch of a new mobile app for Typo. Important details concerning this proposal is provided below:

• The cost to develop the new app will be $2.5 million. This cost will be amortised using the straight line method over the 5 year life of the app.
• The firm will spend $500,000 during year 1 to promote the app.
• As a result of the introduction of the app, sales revenue is expected to grow by $1,820,000 in year 1. This is expected to increase by 2% p.a. over the life of the app. On average, cost of sales is expected to be 40% of sales revenue.
• As a result of the introduction of the app, distribution costs are expected to grow by $60,000 in year 1. These costs are expected to increase by 1.5% p.a. over the life of the app.
• Other ongoing costs to maintain the app are expected to be $80,000 p.a. over the life of the app.
• At the end of years 2 and 4, the new app will require a major update. Each of these updates will cost $80,000.

The firm’s tax rate is 30%. The firm requires a 16% required rate of return on all potential investments. All calculations must be performed in Excel.

Required

In relation to the above proposal:

1. Calculate the annual after tax cash flows and annual after tax profit .
2. Calculate the payback period .
3. Calculate the net present value .
4. Calculate the internal rate of return.
5. Calculate the accounting rate of return.
6. Provide an overview of key environmental factors that the firm should consider when evaluating the proposal .
7. Based on an assessment of the above and other factors, discuss whether the firm should go ahead with the proposal .
8. Discuss how sensitive your recommendations are to changes in assumptions in regards to the financial impact of the new capital investment. In your discussion, include examples which illustrate how changes to at least two assumptions impact the financial analysis .

Answer 1

Particulars	year 1	Year 2	Year 3	Year 4	year 5
Sales	1820000	1856400	1893528	1931400	1970028
less: cost of sales	728000	742560	757411	772560	788011
less: depreciation	500000	500000	500000	500000	500000
les: distribution cost	60000	60900	61814	62740	63682
less: advertisement	500000	0	-0	0	0
less: update cost	80000	160000	80000	160000	80000
Profit before tax	(48000)	392940	494303	436100	538335
Tax @30%	0	117882	148291	130830	161500
Profit after tax	(48000)	275058	346012	305270	376834
Add: depreciation	500000	500000	500000	500000	500000
Cash inflow after tax	452000	775058	846012	805270	876834
Discounting factor @16%	.8620	.7432	.6406	.5523	.4761
PV	389624	576023	541955	444751	417461
cumulative cash inflow	452000	1227058	2073070	2878340	3755174

Net present value = 389624+576023+541955+444751+417461-2500000= (130186)

payback period = year 3 +(2500000-2073070)/805270 =3.5301years

for accounting rate of return, profit after tax is considered.

total after tax profit = 1255174

average after tax profit =251035

Accounting rate of return = 251035/2500000 =10.04%