Question

Given the following information, determine the feasibility of this investment.

Veronika has a great idea for a new online game for mobile devices. The game allows players to destroy alien invaders, which is nothing new, but it also serves as a social engagement app that will allow gamers to connect with other gamers that share their interest, similar to existing dating services. By combining game playing with dating, she thinks she can reach a new market, but she fully expects that others will copy her. Therefore, she assumes that this is a limited time opportunity.

Veronika estimates that it will cost about $175,000 to hire a game engineering contractor to build the app. Once it is built, the engineering firm will receive $0.18 per download as a royalty. The cloud hosting platform firm will charge them $0.12 per month per active user. Veronika will have to spend $25,000 each of the first         two years to market the game. She projects that the game will probably last only about four years, with           downloads and users dropping off after the first two years. There will be no salvage costs (terminal value) after the end of the four years. Downloading the app will cost users $1.99 as a one-time fee. In addition to the   revenue from the downloads, she expects to earn about $0.78 per month per active user in advertising and promotion revenue. Her annual projections for downloads and average monthly users are shown below.

Year	Downloads	Avg Monthly Users
1	250,000	18,750
2	150,000	22,000
3	60,000	12,000
4	30,000	8,000

She also expects to incur $240,000 per year in other operating costs the first year, but that amount should decrease to $200,000 in the second year and then down to $100,000 per year in years three and four.

The $175,000 of development costs are amortized for tax purposes for three years under a special tax incentive law. She can claim 60 percent of the development cost in Year 1, 35 percent in year 2, and the final 5 percent in year 3. The cost of capital to discount the future cash flows is 15 percent, and the average tax rate is 30 percent.

Create a spreadsheet named LastName_FirstName_HW03.xlsx to compute the NPV, IRR, PI, and Payback for this project and interpret the results. You will have to calculate the initial investment at time zero and the after-tax operating cash flows for Years 1 through 4 to calculate the NPV, IRR, PI, and Payback. Remember to convert "monthly" into "annual" when computing revenue and expense per year. After computing the relevant financial metrics, make a recommendation to Veronika and justify that recommendation by citing the information you have generated in your spreadsheet. Set up your spreadsheet so that the instructor can follow your calculations.

Answer 1

Step 1: Calculate After-Tax Operating Cash Flows

The value of annual cash flows is arrived with the use of following table:

	Annual After-Tax Operating Cash Flows
	0	1	2	3	4
Initial Investment	-175,000
Revenue from App Download		497,500 (250,000*1.99)	298,500 (150,000*1.99)	119,400 (60,000*1.99)	59,700 (30,000*1.99)
Advertising and Promotion Revenue		175,500 (18,750*12*.78)	205,920 (22,000*12*.78)	112,320 (12,000*12*.78)	74,880 (8,000*12*.78)
Total Revenue (A)		673,000	504,420	231,720	134,580
Less Costs/Expenses:
Royalty Fees		45,000 (250,000*.18)	27,000 (150,000*.18)	10,800 (60,000*.18)	5,400 (30,000*.18)
Hosting Fees		27,000 (18,750*12*.12)	31,680 (22,000*12*.12)	17,280 (12,000*12*.12)	11,520 (8,000*12*.12)
Marketing Costs		25,000	25,000	0	0
Operating Costs		240,000	200,000	100,000	100,000
Amortization of Development Costs		105,000 (175,000*60%)	61,250 (175,000*35%)	8,750 (175,000*5%)	0
Total Costs (B)		442,000	344,930	136,830	116,920
EBT (A-B)		231,000	159,490	94,890	17,660
Less Taxes (EBT*30%)		69,300	47,847	28,467	5,298
EAT		161,700	111,643	66,423	12,362
Add Amortization of Development Costs		105,000	61,250	8,750	0
After-Tax Operating Cash Flow	-$175,000	$266,700	$172,893	$75,173	$12,362

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Step 2: Calculate NPV

NPV is the difference between the present value of cash inflows and outflows. It can be calculated with the use of following formula:

NPV = Cash Flow Year 0 + Cash Flow Year 1/(1+Cost of Capital)^1 + Cash Flow Year 2/(1+Cost of Capital)^2 + Cash Flow Year 3/(1+Cost of Capital)^3 + Cash Flow Year 4/(1+Cost of Capital)^4

The NPV has been calculated as follows:

	0	1	2	3	4
Initial Investment	-175,000
Revenue from App Download		497,500	298,500	119,400	59,700
Advertising and Promotion Revenue		175,500	205,920	112,320	74,880
Total Revenue (A)		673,000	504,420	231,720	134,580
Less Costs/Expenses:
Royalty Fees		45,000	27,000	10,800	5,400
Hosting Fees		27,000	31,680	17,280	11,520
Marketing Costs		25,000	25,000	0	0
Operating Costs		240,000	200,000	100,000	100,000
Amortization of Development Costs		105,000	61,250	8,750	0
Total Costs (B)		442,000	344,930	136,830	116,920
EBT (A-B)		231,000	159,490	94,890	17,660
Less Taxes (EBT*30%)		69,300	47,847	28,467	5,298
EAT		161,700	111,643	66,423	12,362
Add Amortization of Development Costs		105,000	61,250	8,750	0
After-Tax Operating Cash Flow (C)	-175,000	266,700	172,893	75,173	12,362
PVIF (D)	1	0.8696 [1/(1+15%)^1]	0.7561 [(1/(1+15%)^2]	0.6575 [1/(1+15%)^3]	0.5718 [1/(1+15%)^4]
Present Value of Cash Flows (C*D)	-175,000	231,913	130,732	49,427	7,068
NPV	$244,140.47

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Step 3: Calculate IRR

IRR is the minimum rate of return acceptable from a project. IRR can be calculated with the use of IRR function of EXCEL/Financial Calculator. The basic formula for calculating IRR is given as below:

NPV = 0 = Cash Flow Year 0 + Cash Flow Year 1/(1+IRR)^1 + Cash Flow Year 2/(1+IRR)^2 + Cash Flow Year 3/(1+IR)^3 + Cash Flow Year 4/(1+Cost of Capital)^4

IRR is calculated with the use of EXCEL as below:

where IRR = IRR(B17:F17) = 109.96%

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Step 4: Calculate Profitability Index

The value of profitability index is determined as follows:

Profitability Index = Present Value of Cash Inflows/Initial Investment

where Present Value of Cash Inflows = Cash Flow Year 1/(1+Cost of Capital)^1 + Cash Flow Year 2/(1+Cost of Capital)^2 + Cash Flow Year 3/(1+Cost of Capital)^3 + Cash Flow Year 4/(1+Cost of Capital)^4

The profitability index is calculated with the use of table given below:

	Annual Cash Flows
	0	1	2	3	4
Initial Investment	-175,000
Revenue from App Download		497,500	298,500	119,400	59,700
Advertising and Promotion Revenue		175,500	205,920	112,320	74,880
Total Revenue (A)		673,000	504,420	231,720	134,580
Less Costs/Expenses:
Royalty Fees		45,000	27,000	10,800	5,400
Hosting Fees		27,000	31,680	17,280	11,520
Marketing Costs		25,000	25,000	0	0
Operating Costs		240,000	200,000	100,000	100,000
Amortization of Development Costs		105,000	61,250	8,750	0
Total Costs (B)		442,000	344,930	136,830	116,920
EBT (A-B)		231,000	159,490	94,890	17,660
Less Taxes (EBT*30%)		69,300	47,847	28,467	5,298
EAT		161,700	111,643	66,423	12,362
Add Amortization of Development Costs		105,000	61,250	8,750	0
After-Tax Operating Cash Flow	-175,000	266,700	172,893	75,173	12,362
PVIF		0.8696	0.7561	0.6575	0.5718
Present Value of Cash Inflows		231,913	130,732	49,427	7,068
Total Present Value of Cash Inflows (D)		419,140
Initial Investment (E)		175,000
Profitability Index (D/E)		2.40

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Step 4: Determine Payback Period

Payback period is the period within the initial investment is recovered with the use of after-tax operating cash flows. As the value of initial investment is less than the after-tax operating cash flow for the year, we can conclude that the payback period is less than 1 Year.The exact value of payback period is calculated as below:

Payback Period = Initial Investment/After-Tax Operating Cash Flow for Year 1 = 175,000/266,700 = .66 or 7 months

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Step 5: Recommendation

Veronika should invest in the project as it results in a positive NPV. Also, the internal rate of return is greater than the cost of capital and profitability index is greater than 1. Not only that, the total amount invested by Veronika gets recovered in the first year itself. Therefore, it is an ideal project for investment.