Question

Innovation Company is thinking about marketing a new software product. Upfront costs to market and develop the product are $5,300,000. The product is expected to generate profits of $1,000,000 per year for ten years. The company will have to provide product support expected to cost $92,000 per year in perpetuity. Assume all income and expenses occur at the end of each year.

a. What is the NPV of this investment if the cost of capital is 4.76%​?

Should the firm undertake the​ project? Repeat the analysis for discount rates of 2.75% and 9.57%​, respectively.

b. How many IRRs does this investment opportunity​ have?

​(Hint​: Consider the two alternative discount rates we used in our analysis in part​ a.)  

c. Can the IRR rule be used to evaluate this​ investment? Explain.

Answer 1

NPV is the profitability of the project. It is the difference between present value of cash inflow - capital outlay.

i.e NPV = PVCI- Capital Outlay

Cashflows are discounted at present value using the discount factor.

Capital Outlay = 5300000

Cash flows each year = 1000000-92000= 908000

a) We find PVCI using financial calculator

Feed PMT = 908000

I.Y = 4.76

N = 10

FV = 0

Compute PV, we get 7093776.94

Hence NPV =  7093776.94 - 53000000 = 1,793,776.94

As NPV is positive, firm should select the project

Using the same steps Recomputing PVCI with I/Y = 2.75, we get 7,845,189.16 and NPV = 2545189.16

Using the same steps Recomputing PVCI with I/Y = 9.57, we get 5,683,836.25 and NPV = 383,836.25

b)IRR is the rate which equates PVCI and Capital Outlay. It is the rate at which NPV is nil

We calculate the IRR using financial calculator:
PV = -5300000

PMT = 908000

FV = 0

N =10

Compute IY we get 11.21%

c) As IRR is above the cost of capital, we may accept the project.