Question

Innovation Company is thinking about marketing a new software product. Upfront costs to market and develop the product are $4.92 million. The product is expected to generate profits of $1.14 million per year for 10 years. The company will have to provide product support expected to cost $94,000 per year in perpetuity. Assume all profits and expenses occur at the end of the year.

What is the NPV of this investment if the cost of capital is 6.2%​?Should the firm undertake the​ project? Repeat the analysis for discount rates of1.2%and16.5%​ respectively.

Answer 1

Given

Initial investment = $4.92 million

Cash inflow (Profit) per year for 10 years = $1.14 million

Maintenance cost per year in perpetuity = $94,000

The expense peryear is in perpetuity, therefore present value of such cost = Expense/Cost of capital

Net Present Value of project is the net cashflows for a period of time.

NPV = (Present value of cash Inflows - Present Value of cash outflows) - Initial Investment

Cost of capital - 6.2%

NPV = [1.14 × PVAF_{(6.2%,10 years)} - (0.094/0.062)] - 4.92 = [(1.14 × 7.291) - 1.516] - 4.92

= 6.80 - 4.92

= $ 1.88 million

Here the NPV is positive, therefore the firm should undertake the project.

Cost of capital - 1.2%

NPV = [1.14 × PVAF_{(1.2%,10years)} - (0.094/0.012)] - 4.92

= [(1.14 × 9.37) - 7.83] - 4.92

= 2.85 - 4.92

= - $ 2.07 million

Here NPV is negative, the firm should not undertake the project.

Cost of capital - 16.5%

NPV = [1.14× PVAF_{(16.5%,10years)} - (0.094/0.165)] - 4.92]

= [(1.14 × 4.745) -0.57] - 4.92

= 4.84 - 4.92

= -$ 0.08 million

NPV is negative, therefore the firm should not undertake the project.