Question

Innovation Company is thinking about marketing a new software product. Upfront costs to market and develop the product are $5,200,000. The product is expected to generate profits of $1,300,000 per year for ten years. The company will have to provide product support expected to cost $93,000 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 5.17% Should the firm undertake the​ project? Repeat the analysis for discount rates of 1.34% and 18.72%​ 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

Answer a.

Year	Upfront cost (1)	Profit (2)	Cost (3)	Total cashflow (4)=(1+2+3)	Dis factor @5.17% (5)	Dis factor @1.34% (6)	Dis factor @18.72% (7)	Dis cashflow @5.17% (4*5)	Dis cashflow @1.34% (4*6)	Dis cashflow @18.72% (4*7)
0	-5200000			-5200000	1	1	1	- 5,200,000	-       5,200,000	-       5,200,000
1		1300000	-93000	1207000	0.950841	0.986777	0.842318	1,147,666	1,191,040	1,016,678
2		1300000	-93000	1207000	0.9041	0.973729	0.7095	1,091,248	1,175,291	856,366
3		1300000	-93000	1207000	0.859655	0.960854	0.597624	1,037,604	1,159,751	721,333
4		1300000	-93000	1207000	0.817396	0.948149	0.50339	986,597	1,144,415	607,592
5		1300000	-93000	1207000	0.777214	0.935611	0.424014	938,097	1,129,283	511,785
6		1300000	-93000	1207000	0.739007	0.92324	0.357155	891,982	1,114,351	431,086
7		1300000	-93000	1207000	0.702679	0.911032	0.300838	848,133	1,099,616	363,112
8		1300000	-93000	1207000	0.668136	0.898986	0.253401	806,440	1,085,076	305,855
9		1300000	-93000	1207000	0.635292	0.887099	0.213445	766,797	1,070,728	257,628
10		1300000	-93000	1207000	0.604062	0.875369	0.179788	729,102	1,056,570	217,004
Total								4,043,667	6,026,120	88,438
NPV								4,043,667	6,026,120	88,438

Firm should undertake the project in case of all the three dis factor since NPV is positive.

Answer B

There is only one IRR 19%.

Year	Upfront cost (1)	Profit (2)	Cost (3)	Total cashflow (4)=(1+2+3)
0	-5200000			-5200000
1		1300000	-93000	1207000
2		1300000	-93000	1207000
3		1300000	-93000	1207000
4		1300000	-93000	1207000
5		1300000	-93000	1207000
6		1300000	-93000	1207000
7		1300000	-93000	1207000
8		1300000	-93000	1207000
9		1300000	-93000	1207000
10		1300000	-93000	1207000
IRR				19%	IRR(L20:L30)

If the IIR is higher than the discount rate the project is good to pursue. IRR 19% is higher than all the three discount rates. Hence it should be executed.