Question

You are the financial manager for a firm and the product development team has proposed the development of a software product that will cost $1,000,000 currently to produce but will bring in cashflows of $200,000 for the next 6 years. You know that the firm can invest the firm’s retained earnings in the stock market and earn 6% over the same period. Should you greenlight the development of the new product or not? If you only expect to earn 5% on invested funds how, if at all, would your answer change?

Answer 1

Net Present Value of the Proposed Project if the Interest Rate is 6%

Year	Annual Cash Flow ($)	Present Value factor at 6%	Present Value of Cash Flow ($)
1	2,00,000	0.94340	1,88,679.25
2	2,00,000	0.89000	1,77,999.29
3	2,00,000	0.83962	1,67,923.86
4	2,00,000	0.79209	1,58,418.73
5	2,00,000	0.74726	1,49,451.63
6	2,00,000	0.70496	1,40,992.11
TOTAL			9,83,464.87

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $9,83,464.87 - $10,00,000

= -$16,535.13 (Negative NPV)

Decision

“NO”. The Proposed Project at 6% Interest should not be accepted, since the Net Present Value of the Project is -$16,535.13 (Negative NPV)

Net Present Value of the Proposed Project if the Interest Rate is 5%

Year	Annual Cash Flow ($)	Present Value factor at 5%	Present Value of Cash Flow ($)
1	2,00,000	0.95238	1,90,476.19
2	2,00,000	0.90703	1,81,405.90
3	2,00,000	0.86384	1,72,767.52
4	2,00,000	0.82270	1,64,540.49
5	2,00,000	0.78353	1,56,705.23
6	2,00,000	0.74622	1,49,243.08
TOTAL			10,15,138.41

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $10,15,138.41 – $10,00,000

= $15,138.41

Decision

“YES” The Proposed Project at 5% Interest Rate should be accepted, since the Net Present Value of the Project is Positive $15,138.41

NOTE

The Formula for calculating the Present Value Factor is [1/(1 + r)ⁿ], Where “r” is the Discount/Interest Rate and “n” is the number of years.