Question

As a senior analyst for the company you have been asked to evaluate a new IT software project. The company has just paid a consulting firm $100,000 for a test marketing analysis. After looking at the project plan, you anticipate that the project will need to acquire computer hardware for a cost of $450,000. The Australian Taxation Office rules allow an effective life for the computer hardware of five years. The equipment can be depreciated on a straight-line (prime cost) basis and there is no expected salvage value after the five years. Your company does not have any available space where the project can be located for five years and you anticipate a new office will cost $65,000 to rent for the first year (same cost for the remaining years). You expect that the project will need to hire 3 new software specialists at $50,000 (each specialist) per year (start in year 1) for the full five years to work on the software (same cost for the remaining years). The project will use a van currently owned by the company. Although the van is not currently being used by the company, it can be rented out for $15,000 per year for five years. The book value of the van is $20,000. The van is being depreciated straight-line (with five years remaining for depreciation) and is expected to be worthless after the five years. Expected annual marketing and selling costs will be incurred during the life of the project (5 years), with the first year expecting to be $250,000. The produced software is expected to sell at $85 per unit while the cost to produce each unit is $40. You expect that 10,000 units will be sold in the first year and the number of units sold will increase by 25% a year for the remaining four years. The project will need working capital of $50 000 to commence the business (in year 0) and the investment in working capital is to be completely recovered by the end of the project’s life (in year 5). The company tax rate is 30%, and the discount rate is 10.5%.

Please Calculate the incremental free cash flow during the project’s life (starting from year 0 to year 5). Show workings.

Calculate the NPV, payback period and IRR of the project. Should the project be accepted? Show workings and explain your answer(s). It is important to show workings, such as formula(e) and input of each variable in the formula(e) Please ensure workings are presented clearly. Please manual calculations. Thanks.

Answer 1

Year	0	1	2	3	4	5
1.Cost of computer hardware	-450000
2.NWC reqd. & recovered	-50000					50000
Incremental cashflows:
3.No.of units of sales		10000	12500	15625	19531	24414
4.Sales $ at $ 85/unit(3*$85)		850000	1062500	1328125	1660156	2075195
5.Costs to produce at $ 40/unit(3*$40)		-400000	-500000	-625000	-781250	-976562.5
6.Office rent		-65000	-65000	-65000	-65000	-65000
7.Hire costs of 3 software specialists(50000*3)		-150000	-150000	-150000	-150000	-150000
8.Van rental income lost		-15000	-15000	-15000	-15000	-15000
9.Marketing & selling costs		-250000	-250000	-250000	-250000	-250000
10.Depn.(st.line)		-90000	-90000	-90000	-90000	-90000
11.Incl.EBIT(sum 4 to 10)		-120000	-7500	133125	308906	528633
12. Tax at 30%(11*30%)		36000	2250	-39938	-92672	-158589.8
13. EBT(11+12)		-84000	-5250	93188	216234	370043
14.Add Back: Incl.depn.(line 10)		90000	90000	90000	90000	90000
15.Opg. Cash flows(13+14)		6000	84750	183188	306234	460043
16.Annual FCFs(1+2+15)	-500000	6000	84750	183188	306234	510043
17.PV F at 10.5%(1/1.105^Yr.n)	1	0.904977	0.818984	0.741162	0.670735	0.607
18.PV at 10.5%(16*17)	-500000	5430	69409	135772	205402	309596
19.NPV(sum of line 18)	225608
20. IRR(Of FCF line 16)	21.35%
21.Payback period:
Cumulative FCFs	-500000	-494000	-409250	-226063	80172	590215
Payback period=
3+(220063/306234)=	3.72	Years
The project can be accepted   as
the NPV is POSITIVE
IRR of the incl. CFs, 21.35% > COC, 10.5%
Pays back by 3.72 yrs.< project life,5 yrs.