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IT Software Project As a senior analyst for the company, you have been asked to evaluate...
IT 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.
3. Calculate the NPV, payback period and IRR of the project. Should the project be accepted? Show workings and explain your answer(s).
Solutions
Expert Solution
1) The amount of $100,000 incurred by the company for testing marketing analyst is not to be considered for decision making of adopting new project as it is sunk cost for the new project, i.e, it will be incurred irrespective of the project is undertaken or not. Also, the cost incurred is not only for marketing analysis but for project analysis as a whole.
2) Incremental cash flow for a new project = Initial Investment + Operating cash flows + Terminal Cashflow
| (Outflow)/Inflow | Amount in $ | |||||
| Description | Initial Investment(Y0) | Y1 | Y2 | Y3 | Y4 | Terminal Cashfolw (Y5) |
| $100,000 for testing market analysis is a sunk cost | ||||||
| Units sold | 10,000.00 | 12,500.00 | 15,625.00 | 19,531.25 | 24,414.06 | |
| Net operating profit (Units sold*(85-40)) | 450,000.00 | 562,500.00 | 703,125.00 | 878,906.25 | 1,098,632.81 | |
| Depreciation on computer hardware (450000/5) | (90,000.00) | (90,000.00) | (90,000.00) | (90,000.00) | (90,000.00) | |
| Office Space rent | (65,000.00) | (65,000.00) | (65,000.00) | (65,000.00) | (65,000.00) | |
| 3 software specialist salary (50000*3) | (150,000.00) | (150,000.00) | (150,000.00) | (150,000.00) | (150,000.00) | |
| Opportunity cost of rental from Van | (15,000.00) | (15,000.00) | (15,000.00) | (15,000.00) | (15,000.00) | |
| Depreciation on Van (20000/5) | (4,000.00) | (4,000.00) | (4,000.00) | (4,000.00) | (4,000.00) | |
| Annual marketing and selling cost | (250,000.00) | (250,000.00) | (250,000.00) | (250,000.00) | (250,000.00) | |
| Operating Income | (124,000.00) | (11,500.00) | 129,125.00 | 304,906.25 | 524,632.81 | |
| Tax @30% of operating income | 37,200.00 | 3,450.00 | (38,737.50) | (91,471.88) | (157,389.84) | |
| NOPAT | (86,800.00) | (8,050.00) | 90,387.50 | 213,434.38 | 367,242.97 | |
| Depreciation | 94,000.00 | 94,000.00 | 94,000.00 | 94,000.00 | 94,000.00 | |
| Operating cashflows | 7,200.00 | 85,950.00 | 184,387.50 | 307,434.38 | 461,242.97 | |
| Working Capital | (50,000.00) | 50,000.00 | ||||
| Computer Hardware | (450,000.00) | |||||
| Incremental cash flow | (500,000.00) | 7,200.00 | 85,950.00 | 184,387.50 | 307,434.38 | 511,242.97 |
3)
| Description | Initial Investment(Y0) | Y1 | Y2 | Y3 | Y4 | Terminal Cashfolw (Y5) | |
| a) | Incremental cash flow | (500,000.00) | 7,200.00 | 85,950.00 | 184,387.50 | 307,434.38 | 511,242.97 |
| b) | Discounting factor @10.5% | 1 | 0.904977376 | 0.81898405 | 0.741162036 | 0.670734875 | 0.606999887 |
| c) | Present Value (NPV) (a*b) | (500,000.00) | 6,515.84 | 70,391.68 | 136,661.01 | 206,206.96 | 310,324.42 |
| d) | Net Present Value | 230,099.91 | |||||
| e) | Cumulative cash flows | (500,000.00) | (492,800.00) | (406,850.00) | (222,462.50) | 84,971.88 | 596,214.84 |
| f) | Payback Period (3years + (222462.5/(84971.88+222462.5))) | 3.72 years | |||||
| g) | IRR (Rate at which NPV=0) | ||||||
| NPV @10.5% | 230,099.91 | ||||||
| NPV @25% | -51376.384 | ||||||
| IRR (10.5+(230099.91/(230099.91+51376.384)*(25-10.5)) | 22.35 |
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