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 1) 250,000 2) 150,000 3) 60,000 4) 30,000 Avg Monthly Users 1) 18,750 2) 22,000 3) 12,000 4) 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 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.

Answer 1

We can put the information in a worksheet as below:

Please note the following:

a. The monthly per user advertising & promotional revenue and cloud hosting cost has been converted into annual number by multiplying it with 12

b. The Initial Cost of 175000 has been amortised for tax reasons and after the tax calculations, the amortised numbers have been added back to net of tax cash flows to arrive at the final cash flows for the firm - these have been used for the NPV, IRR, PI and Payback calculations

As we can see from the projected cash flows and financial metrics we have calculated, Veronica should pursue this idea since most of the cash flows are front ended due to which the NPV and IRR are very high and the payback period for the initial outlay is also less than 1 year.