Question

Your firm has been hired to develop new software for the​ university's class registration system. Under the​ contract, you will receive

$ 506 comma 000

as an upfront payment. You expect the development costs to be

$ 433 comma 000

per year for the next

3

years. Once the new system is in​ place, you will receive a final payment of

$ 833 comma 000

from the university

4

years from now.

a. What are the IRRs of this​ opportunity?  ​ (Hint: Build an Excel model which tests the NPV at​ 1% intervals from​ 1% to​ 40%. Then zero in on the rates at which the NPV changes​ signs.)

b. If your cost of capital is

10 %

​,

is the opportunity​ attractive?

Suppose you are able to renegotiate the terms of the contract so that your final payment in year

4

will be

$ 1.2

million.  

c. What is the IRR of the opportunity​ now?

d. Is it attractive at the new​ terms?

Answer 1

a)

The excel model is built using the NPV function in excel. The formula used in calculating the NPV for interest rates between 1% and 40% is shown as below.

The formulas used to build the excel model is shown as below.

The opportunity has two IRR's as the NPV changes sign twice i.e. once at 10% interest rate and another time at 24% interest rate.

The opportunity is not attractive because the IRR is equal to the cost of capital of 10% and also due to presence of multiple IRR, we cannot decide which IRR to choose. Hence the opportunity is not attractive.

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c) After renegotiating the terms of the contract, the IRR of the cash flows cannot be determined because the cash flows are unconventional. The IRR is indeterminate.

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d)

Even at the new terms, the opportunity is not attractive because the IRR is indeterminate.