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 $50,000 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 $400,000. 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 $80,000 to rent for the first year. You expect that the project will need to hire 3 new software specialists at $50,000 (each specialist) in the first year for the full five years to work on the software. The project will use a van currently owned by the company and although the van is not currently being used by the company, it can be rented out for $5,000 per year for five years (inclusive inflation). 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 $200,000. The produced software is expected to sell at $100 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 20% 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%.

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

1. In evaluating the new IT software project, are the cost of $50,000 spent on marketing analysis and the use of van relevant for capital budgeting decision? Explain your answer(s). Show workings.

2. Calculate the incremental free cash flow during the project’s life (at the end of Years 1 through 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).

Answer 1

1. In evaluating the new IT software project,

Given that the company has just paid a consulting firm $50,000 for a test marketing analysis, $ 50000 had already been spent ,so nothing can be done about it now, or in future. So.it is not a relevant cost ,concerning this analysis.

Regarding the use of van,

Given that "although the van is not currently being used by the company, it can be rented out for $5,000 per year for five years"

so, that $ 5000 rental income will be lost to the company, if the van is used in this project.

so, $ 5000 /year becomes a relevant cost for this project--ie. Opportunity cost of rental income lost .

But the book value or salvage value of the van are not relevant for this analysis.

Also,as the depreciation is being claimed already, the company is not going to have any incremental cash flow(tax saving due to depreciation), on this account. So, depreciation of the van is also not relevant.

2. Incremental cash flows
Year	0	1	2	3	4	5
1.Cost of computer hardware	-400000
2.NWC introd. & recovered	-50000					50000
Incl.Operating cash flows:
3.Units sold		10000	12000	14400	17280	20736
4.Sales $ at $100/unit(3*$100)		1000000	1200000	1440000	1728000	2073600
5.Cost at $40 /unit(3*$ 40)		-400000	-480000	-576000	-691200	-829440
6.Office rent		-80000	-80000	-80000	-80000	-80000
7.Software specialists'salary(50000*3)		-150000	-150000	-150000	-150000	-150000
8.Opportunity cost of rental income lost on van		-5000	-5000	-5000	-5000	-5000
9.Depreciation		-80000	-80000	-80000	-80000	-80000
10.Expected annual marketing and selling costs		-200000	-200000	-200000	-200000	-200000
11.EBT(sum 4 to 10)		85000	205000	349000	521800	729160
12.Tax at 30%(11*30%)		-25500	-61500	-104700	-156540	-218748
13.EAT(11-12)		59500	143500	244300	365260	510412
14.Add back:Depn.(same row 9)		80000	80000	80000	80000	80000
15.Incl.Opg. Cash flow(13+14)		139500	223500	324300	445260	590412
16.Net annual FCFs(1+2+15) (ANSWER:2)	-450000	139500	223500	324300	445260	640412
17.PV F at 10%(1/1.1^Yr.n)	1	0.90909	0.82645	0.75131	0.68301	0.62092
18.PV at 10%(16*17)	-450000	126818.2	184710.7	243651.4	304118.6	397645.5
19.NPV at 10%(sum of row 18)	806944.4
20.IRR(Of FCF row 16)	51.21%
Computing IRR manually,
0= -450000+(139500/(1+r)^1)+(223500/(1+r)^2)+(324300/(1+r)^3)+(445260/(1+r)^4)+(640412/(1+r)^5)
& solving for r,
r=IRR=51.21%
Payback period
16.Net annual FCFs(1+2+15) (ANSWER:2)	-450000	139500	223500	324300	445260	640412
Cumulatice fc/fs	-450000	-310500	-87000	237300	682560	1322972
Payback period=
2+(87000/324300)=
2.27
Years
3...YES.
The project can be accepted for the following reasons:
POSITIVE NPV
IRR 51.21% > COC 10%
Payback period-- 2.27 yrs. Well less than project's life 5 yrs.