Question

You are running a small software firm producing games for mobile devices and are considering introducing a new adventure game to customers. You plan to sell the product for the next 3 years and then exit before the competition catches up.  Based on the market research done last year for $30,000, you believe that, in year 1, the project will generate $4,800,000 of revenue with the cost of goods sold of $2,850,000. The revenue and the cost will diminish by 2% each year after that. The project will immediately require new computer equipment valued at $1,800,000. This equipment will be depreciated to $0 over 3 years using the straight-line method. The net working capital will increase immediately by $400,000 from the current level, stay at the level in year 1 and then decrease by $250,000 in year 2 and again decrease by $150,000 in year 3, returning to the current level. The introduction of the new game will affect the revenues from your other existing adventure games negatively by $190,000 per year.

Forecast all of the annual free cash flows for this project, and then compute its net present value and IRR using a discount rate of 9%. Is this project worth taking? Your company’s tax rate is 35%.

Answer 1

Computation of Net Present Value

Net present value = Present value of cash inflows - Present value of cash outflows

= 3,367,278 - 2,693,224

= $674,054

Since the NPV >0, hence it is worth taking the project.

Particulars	Year 0	Year 1	Year 2	Year 3	Total
Initial cost	(1,800,000)	-	-	-	(1,800,000)
Net working capital requirement	(400,000)	(400,000)	(150,000)	-	(950,000)
Net cash outflows	(2,200,000)	(400,000)	(150,000)	-	(2,750,000)
PVF @ 9%	1.00	0.917	0.842	0.772
Present value of cash outflows	(2,200,000)	(366,972)	(126,252)	-	(2,693,224)

Particulars	Year 1	Year 2	Year 3	Total
Annual revenue	4,800,000	4,704,000	4,609,920	14,113,920
Cost of goods sold	(2,850,000)	(2,793,000)	(2,737,140)	(8,380,140)
Loss of revenue	(190,000)	(190,000)	(190,000)	(570,000)
Depreciation	(600,000)	(600,000)	(600,000)	(1,800,000)
Cash flows before tax	1,160,000	1,121,000	1,082,780	3,363,780
Tax @ 35%	(406,000)	(392,350)	(378,973)	(1,177,323)
Cash flows after tax (A)	754,000	728,650	703,807	2,186,457
Add : Depreciation (B)	600,000	600,000	600,000	1,800,000
Net cash inflows (A)+(B)	1,354,000	1,328,650	1,303,807	3,986,457
PVF @ 9%	0.917	0.842	0.772
Present value of cash inflows	1,242,202	1,118,298	1,006,778	3,367,278

Computation of IRR

IRR is the rate at which net present value of all the cash flows is equal to 0.

To compute the IRR, we will b using hit and trial method and then interpolation method.

At a discount rate of 25%, NPV = PV of cash inflows - PV of cash outflows

= 2,601,085 - 2,616,000

= - $14,915

Hence IRR falls between 9% and 25%. To arrive at the exact IRR we will be using interpolation method.

IRR = 9% + [674,054 - 0 / 674,054 - (-14,915)] * (25%-9%)

= 9% + 15.65%

= 24.65%