Question

Innovation Company is thinking about marketing a new software product. Upfront costs to market and develop the product are $ 4.91 million. The product is expected to generate profits of $ 1.15 million per year for ten years. The company will have to provide product support expected to cost $ 96,000 per year in perpetuity. Assume all profits and expenses occur at the end of the year.

a. What is the NPV of this investment if the cost of capital is 6.5 %​? Should the firm undertake the​ project? Repeat the analysis for discount rates of 1.2 % and 16.8 %​, respectively.

b. What is the IRR of this investment​ opportunity?  

c. What does the IRR rule indicate about this​ investment?

Answer 1

a. What is the NPV of this investment if the cost of capital is 6.5%? Should the firm undertake the project? Repeat the analysis for discount rates of 1.2% and 16.8%, respectively.

Net present value (NPV) is a method used to determine the current value of all future cash flows generated by a project, including the initial capital investment. It is widely used in capital budgeting to establish which projects are likely to turn the greatest profit. The formula for NPV varies depending on the number and consistency of future cash flows. In the instant case, we have initial investment costs (upfront costs of $ 4.91 mn) and the project yields a profit of $1.15 mn for 10 years, for which an expense of $96,000 per annum has to be incurred. The given date is tabularised and given under:

(Amount in $)

Pariculars	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10
Upfront Costs	(4,910,000.00)
Profits		1,150,000.00	1,150,000.00	1,150,000.00	1,150,000.00	1,150,000.00	1,150,000.00	1,150,000.00	1,150,000.00	1,150,000.00	1,150,000.00
Expenses		(96,000.00)	(96,000.00)	(96,000.00)	(96,000.00)	(96,000.00)	(96,000.00)	(96,000.00)	(96,000.00)	(96,000.00)	(96,000.00)
TOTAL	(4,910,000.00)	1,054,000.00	1,054,000.00	1,054,000.00	1,054,000.00	1,054,000.00	1,054,000.00	1,054,000.00	1,054,000.00	1,054,000.00	1,054,000.00

The formula for calculation of NPV is as under:

​NPV = Cash flow​ / ((1+i)^t − initial investment

where: i=Required return or discount rate; and t=Number of time periods​

The cashflow generated over the years are discounted with the given discount rate and present value of all future cashflows are calculated. The initial investment cost is dedcuted from the present value to calculate the net present value. NPV calculated for the diffferent discount rates provided are as under:

Discount Rates	NPV in $
6.50%	2,504,250.76
1.20%	4,907,599.76
16.80%	30,907.98

If there is only one project is being evaluated, if the NPV is positive, the said Project can be considered by the Firm. If there are multiple projects and capital is a constraint, then the Firm can consider the Project yielding highest NPV.

b. What is the IRR of this investment opportunity?

The internal rate of return (IRR) is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. IRR calculations rely on the same formula as NPV does. It takes lot of iterations to arrive at the rate, if IRR is being calculated manually using formulas.

The IRR of this investment opportunity is 17.00%

c. What does the IRR rule indicate about this investment?

If the IRR is more than the cost of capital, then the Project can be considered by the Firm.