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%.

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

2.  Calculate the NPV, payback period and IRR of the project. Should the project be accepted? Show workings and explain your answer(s).

Answer 1

1. $100000 paid to consulting cost is Sunk cost and irrelevant in decison making. So not considering this in further calculations.

2. PV of Cash Outflows: Cost of Compuet hardware = $450000

Working CApital = $50000

Total = $500000

3. Calculation of Free Cash Flows to firm in next 5 years

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5
Sales Unit	10000	12500	15625	19531.25	24414.06
Contribution @ 45 (85-40)	450000	562500	703125	878906.3	1098633
Less : Office Rent	65000	65000	65000	65000	65000
Less:Salary Software sopecialist	150000	150000	150000	150000	150000
Less :Depriciation =450000/5	90000	90000	90000	90000	90000
Less: Marketing and Selling cost =250000/10000= 25 per unit	250000	312500	390625	488281.3	610351.6
Less: Net Profit	-105000	-55000	7500	85625	183281.3
Less: Taxes @ 30 % Loss of 1st and 2nd year of 160000 Adjusted in 3rd year 7500 4th year 85625 5th year 66875 Tax of 5th year =183281.3-66875=116406.3 then 116406.3x30%=34922	-	-	-	-	34922
Net profit after taxes	-105000	-55000	7500	85625	148359.3
Add: Depreciation	90000	90000	90000	90000	90000
Less :Opportunity Cost, Rent forgone for VAN	15000	15000	15000	15000	15000
Add: Realisation of Working capital	0	0	0	0	50000
Free cash Flows to firm	-30000	20000	82500	160625	273359.3

2. NPV = Pv of cash inflows - Investment = 324031-500000 = - 175969

PV of Cash inflows: =$ 324031

Year 1

Year 2

Year 3

Year 4

Year 5

Free cash Flows to firm	-30000	20000	82500	160625	273359.3
PV factor @ 10.5%	0.905	0.819	0.7411	0.6707	0.607
PV of cash inflows	-27150	16380	61140.75	107731.2	165929.1

Payback period:

	Year 1	Year 2	Year 3	Year 4	Year 5
Free cash Flows to firm	-30000	20000	82500	160625	273359.3
Incremental CAsh Flows	-30000	-10000	72500	233125	506484.3

IRR =

= PV of cash inflow at IRR = pv of cash outflow

we can solve this in texas Ba 2

Put values, CF0= -500000, CF1= -30000, CF2= 20000, CF3= 82500, CF4= 160625, CF5= 273359

Then compute IRR that is 0.288%

Result; Reject the proposal as NPV is Negative.