Question

T Software Project

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%.

Based on the information presented above, answer the following questions (1) – (3).

1. In evaluating the new IT software project, are the cost of $100,000 spent on marketing analysis? Explain your answer(s).

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

Answer 1

1. In Evaluating New IT software project we do not consider Cost spent on Marketing Analysis as same as already been incurred before we took investment decision and does not have any impact on our decision. such cost are called Sunk Cost and not a future cash Flow. such cost are irrelevant for making decision about Investment.
2. Calculation of Incremental Free cash flow are as follows:-

Particulars/Years	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Computer hardware Cost	$ (450,000.00)
Working Capital Infusion	$   (50,000.00)
Net Incremental Cash Flow from Operations		$    (30,000.00)	$      82,500.00	$    211,537.50	$      302,934.38	$ 456,742.97
Working capital Drawing						$    50,000.00
Discounted Rate Applicable	1	$0.90	$0.82	$0.74	$0.67	$0.61
Discounted Cash Flows	(500000.00)	($27,000.00)	$67,650.00	$156,537.75	$202,966.03	$309,113.21

Particulars/Years	Year 1	Year 2	Year 3	Year 4	Year 5
Depreciation on Computer hardware	$   (90,000.00)	$    (90,000.00)	$    (90,000.00)	$    (90,000.00)	$      (90,000.00)
Office Rent	$   (65,000.00)	$    (65,000.00)	$    (65,000.00)	$    (65,000.00)	$      (65,000.00)
Software Specialist Salaries	$ (150,000.00)	$ (150,000.00)	$ (150,000.00)	$ (150,000.00)	$   (150,000.00)
Depreciation from old VAN	$      (4,000.00)	$      (4,000.00)	$      (4,000.00)	$      (4,000.00)	$        (4,000.00)
Selling and Marketing Cost(Annually)	$ (250,000.00)	$ (250,000.00)	$ (250,000.00)	$ (250,000.00)	$   (250,000.00)
Units Manufactured each year	$      10,000.00	$      12,500.00	$      15,625.00	$      19,531.25	$        24,414.06
Contribution Per Unit(SP-VC)	$              45.00	$              45.00	$              45.00	$              45.00	$                45.00
Total Contribution	$   450,000.00	$    562,500.00	$    703,125.00	$    878,906.25	$ 1,098,632.81
Profits	$ (109,000.00)	$        3,500.00	$    144,125.00	$    319,906.25	$      539,632.81
Tax Payment/(Set-off Available)	$   (32,700.00)	$        1,050.00	$      43,237.50	$      95,971.88	$      161,889.84
Tax Payment	$                     -	$                     -	$    (11,587.50)	$    (95,971.88)	$   (161,889.84)
Add: Non- Cash Expenses	$      94,000.00	$      94,000.00	$      94,000.00	$      94,000.00	$        94,000.00
Less: Opportunity Cost of Old VAN	$   (15,000.00)	$    (15,000.00)	$    (15,000.00)	$    (15,000.00)	$      (15,000.00)
Net Incremental Cash Flow from Operations	$   (30,000.00)	$      82,500.00	$    211,537.50	$    302,934.38	$      456,742.97

Few Assumptions:-

1. We have considered Opportunity cost for investment analysis decision because When evaluating a potential investment, include opportunity costs in the analysis. For a capital investment project, a company should evaluate the expected return of the investment compared to the opportunity cost. Opportunity costs are also the expected returns of an alternative investment of equal risk.
2. We have assumed Set-off facility is available in Respect of Taxation.