Question

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
3. Calculate the NPV, payback period, and IRR

Answer 1

In evaluating any project, Sunk costs are considered irrelevant as they are already spent and have no say in decision making. In the given new IT software project, $1,00,000 has already been spent on marketing analysis and hence is a sunk cost and therefore irrelevant.

CALCULATION OF INCREMENTAL FREE CASH FLOW

Particulars	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Hardware	(4,50,000)	0	0	0	0	0
Office Rent	0	(65,000)	(65,000)	(65,000)	(65,000)	(65,000)
Software Specialist	0	(1,50,000)	(1,50,000)	(1,50,000)	(1,50,000)	(1,50,000)
Working Capital	(50,000)	0	0	0	0	50,000
Marketing and Selling costs	0	(2,50,000)	(2,50,000)	(2,50,000)	(2,50,000)	(2,50,000)
Sales Less Cost (WN-1)	0	4,50,000	5,62,500	7,03,125	8,78,895	10,98,630
Tax (WN-2)	0	31,500	(2,250)	(44,438)	(97,168)	(1,63,089)
Van Rent foregone	0	(15,000)	(15,000)	(15,000)	(15,000)	(15,000)
Incremental Free Cash Flow	(5,00,000)	1,500	80,250	1,78,687	3,01,727	5,05,541

Working Notes:

1) Calculation of Sales less Cost:

Sales p.u = $85, Cost p.u = $40 Hence Sales Less Cost p.u = $45

Pariculars	Year1	Year 2	Year 3	Year 4	Year 5
No. of Units	10,000	12,500	15,625	19,531	24,414
Sales Less Cost	4,50,000	5,62,500	7,03,125	8,78,895	10,98,630

2) Calculation of Tax:

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5
Sales Less Cost (WN-1)	4,50,000	5,62,500	7,03,125	8,78,895	10,98,630
Office Rent	(65,000)	(65,000)	(65,000)	(65,000)	(65,000)
Software Specialist	(1,50,000)	(1,50,000)	(1,50,000)	(1,50,000)	(1,50,000)
Marketing and Selling Costs	(2,50,000)	(2,50,000)	(2,50,000)	(2,50,000)	(2,50,000)
Depreciation on Hardware	(90,000)	(90,000)	(90,000)	(90,000)	(90,000)
Profit	(1,05,000)	7,500	1,48,125	3,23,895	5,43,630
Tax	31,500	(2,250)	(44,438)	(97,168)	(1,63,089)

Depreciation on Van will be deducted from Profit irrespective of this Project.

CALCULATION OF NPV

Particulars	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Incremental Free Cash Flow	(5,00,000)	1,500	80,250	1,78,687	3,01,727	5,05,541
Discount Rate @ 10.5%	1	0.905	0.819	0.741	0.671	0.607
Discounted Cash Flow	(5,00,000)	1,358	65,725	1,32,407	2,02,459	3,06,863

NPV of New IT Software Project = $2,08,812

CALCULATION OF PAYBACK PERIOD

Year	Discounted Cash Flow	Cummulative Cash Flow
0	(5,00,000)	(5,00,000)
1	1,358	(4,98,642)
2	65,725	(4,32,917)
3	1,32,407	(3,00,510)
4	2,02,459	(98,051)
5	3,06,863	2,08,812

Payback Period = 4+(98051/306863) = 4.32 years

CALCULATION OF IRR

Particulars	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Total
Incremental Free Cash Flow	(5,00,000)	1,500	80,250	1,78,687	3,01,727	5,05,541
Discount Rate @ 20%	1	0.833	0.694	0.579	0.482	0.402
Discounted Cash Flow @ 20%	(5,00,000)	1,250	55,694	1,03,460	1,45,432	2,03,227	9,063
Discount Rate @ 21%	1	0.826	0.683	0.564	0.467	0.386
Discounted Cash Flow @ 21%	(5,00,000)	1,239	54,811	1,00,779	1,40,907	1,95,139	(7,125)

By Interpolation Method,

IRR = 20 + 9063/(9063+7125) = 20.56%