Question

Innovation Company is thinking about marketing a new software product. Upfront costs to market and develop the product are $4.99 million. The product is expected to generate profits of $1.18 million per year for 10 years. The company will have to provide product support expected to cost $93,000 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 5.7%​? Should the firm undertake the​ project? Repeat the analysis for discount rates of 1.1% and 17.3%​, respectively.

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

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

Answer 1

Initial Investment =4990000
Cost for Perpetuity =93000
At rate =5.7%
PV of Costs =4990000+93000/5.7%=6621578.95
NPV =PV of Cash flows-PV of Costs =1180000*((1-(1+5.7%)^-10)/5.7%)-6621578.95 =2188110.32
Since NPV is positive project should be accepted

At rate =1.1%
PV of Costs =4990000+93000/1.1%=13444545.45
NPV =PV of Cash flows-PV of Costs =1180000*((1-(1+1.1%)^-10)/1.1%)-13444545.45 =-2328123.16
Since NPV is negative project should be rejected

At rate =17.3%
​​​​​​​PV of Costs =4990000+93000/17.3%=5527572.25
NPV =PV of Cash flows-PV of Costs =1180000*((1-(1+17.3%)^-10)/17.3%)-5527572.25 =-89870.01
Since NPV is negative project should be rejected.

b) IRR using formula
PV of Cash Inflows-PV of Costs =0
1180000*((1-(1+IRR)^-10)/IRR)-(4990000+93000/IRR) =0
By hit and trial method there are 2 IRRs
IRR No 1 is 1.59%
IRR no 2 is 16.75%

c) Since there are 2 IRRs it s difficult to use IRR rule to accept or reject projects.