Question

Charm Co, a software company has developed a game, Fingo, which plans to launch in the near future. Sales of Fingo are expected to be very strong, following a favourable review by a popular PC magazine which gave it a best buy recommendation. Information: Year 1 2 3 4 Sales and production (units) 150,000 70,000 60,000 60,000 Selling price $25 $24 $23 $22 Financial information for the 1st year of production: Direct material cost $5.4 per game Other variable production cost $6 per game Fixed costs $4 per game Advertising costs to stimulate demand are expected to be $650,000 in the 1st year of production and $100,000 in the 2nd year. No advertising costs are expected in the 3rd and 4th years of production. Fixed costs represent incremental cash fixed production overheads. Fingo will be produced on a new production machine costing $800,000. Although this production machine is expected to have a useful life of up to ten years, government legislation allows the company to claim the capital cost of the machine against the manufacture of a single product. Capital allowances will therefore be claimed on a straight-line basis over 4 years. The company pays tax on profit at a rate of 30% per year and tax liabilities are settled in the year in which they arise. The company uses an after-tax discount rate of 10% when appraising new capital investments. Required: a) Below we have the NPV that is 13,96,708.20 $. Calculate the Internal Rate of Return (IRR) and comment. b) Discuss why the NPV method is preferred to other investment appraisal methods such as payback, return on capital employed and IRR.

How to find the NPV:

Year2	Year3	Year4
Sales & Production (Units)	150000	70000	60000	60000
Selling Price	25	24	23	22
Sales Value    (Sales unit*Selling Price)	$    37,50,000	$ 16,80,000	$ 13,80,000	$     13,20,000
Expenses:
Direct material Cost @$5.40 (Sales unit*5.4)	$      8,10,000	$    3,78,000	$     3,24,000	$       3,24,000
Other Variable Cost @$6 (Sales unit*6)	$      9,00,000	$    4,20,000	$     3,60,000	$       3,60,000
Advertising Cost	$      6,50,000	$    1,00,000	$                  -	$                    -
Depreciation	$      2,00,000	$    2,00,000	$     2,00,000	$       2,00,000
Total Expenses	$    25,60,000	$ 10,98,000	$     8,84,000	$       8,84,000
Net Income before tax	$    11,90,000	$    5,82,000	$     4,96,000	$       4,36,000
Tax (30%) - (Net Income*30%)	$      3,57,000	$    1,74,600	$     1,48,800	$       1,30,800
Net Income after tax	$      8,33,000	$    4,07,400	$     3,47,200	$       3,05,200
Add:
Depreciation	$      2,00,000	$    2,00,000	$     2,00,000	$       2,00,000
Annual Free Cash Flow	$    10,33,000	$    6,07,400	$     5,47,200	$       5,05,200

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Depreciation (Straight line Method)
Production Cost (Initial Outlay)	$      8,00,000
Salvage Value	Nil
Useful Life	4
Depreciation	$      2,00,000
(800000/4)

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Net Present Value

Year	Annual cash flows	PV Factor @10%	Present Value of cash flows
0	-8,00,000	1	$                         -8,00,000.00
1	10,33,000	0.909	$                           9,38,997.00
2	6,07,400	0.826	$                           5,01,712.40
3	5,47,200	0.751	$                           4,10,947.20
4	5,05,200	0.683	$                           3,45,051.60
	NPV		$                        13,96,708.20

Since Net Present Value is Positive , so the Investment plan is feasible .

Answer 1

a) In order to calculate the IRR, we need to calculate the discount rate when the NPV of the project is 0. Please find below the table showing the IRR calculations.

Discount Rate	0.944666076
Year	Annual cashflows	Discount factor	Present value of cash flows
0	-800000.00	1	-800000
1	1030000.00	0.514227	529653.9
2	607400.00	0.26443	160614.5
3	547200.00	0.135977	74406.52
4	505200.00	0.069923	35325.08
		NPV	0.00

We observe that the NPV of the project turns 0 when the discount rate is 94.47%. Thus the IRR of the project is 94.47%. This appears to be a very healthy rate of return of the project and hence, we should go ahead and pursue the project.

b) NPV is preferred as the ideal method for evaluating a project becasue of the following:

1. NPV shows quantitavely how much of benefil for the particular currency we will be able to gain from the project taking into consideration the time value of money
2. In case of IRR, we would not be use the methodology when there are fluctuating positive and negative cash flows over the years. This would indicate multiple IRRs for the same project.
3. Payback does not properly consider the time value and inflation.
4. NPV is currency specific and the value varies as per the currency and hence we will be able to show the magnitude of change in the currency we require.