Question

Innovation Company is thinking about marketing a new software product. Upfront costs to market and develop the product are $5 million. The product is expected to generate profits of $1 million per year for 10 years. The company will have to provide product support expected to cost $100, 000 per year in perpetuity. Assume all profits and expenses occur at the end of the year.
a. What is the NPV of this investment if the cost of capital is 6%? Should the firm undertake the project? Repeat the analysis for discount rates of 2% and 12%.
b. How many IRRs does this investment opportunity have?
c. Can the IRR rule be used to evaluate this investment? Explain.

Answer 1

Answer:

Explanation:

Initial Cost = $5.00 million

Annual Profit = $1.00 million

Annual Support Cost = $100,000 = $0.10 million

a. )

If Cost of Capital is 6%:

NPV = -$5,000,000 + $1,000,000*(1-(1/1.06)^10)/0.06 - $100,000/0.06

NPV = $693,420.38

Project should be accepted as its NPV is positive.

If Cost of Capital is 2%:

NPV = -$5,000,000 + $1,000,000*(1-(1/1.02)^10)/0.02 - $100,000/0.02

NPV = -$1,017,414.99

Project should be rejected as its NPV is negative.

If Cost of Capital is 12%:

NPV = -$5,000,000 + $1,000,000*(1-(1/1.12)^10)/0.12 - $100,000/0.12

NPV = -$183,110.30

Project should be rejected as its NPV is negative.

b.)

There are two IRR in this opportunity. NPV of this opportunity is 0 when cost of capital is 2.75% and 10.88%. So, IRR are 2.75% and 10.88%

c. )

IRR rule cannot be used to evaluate this investment as it has 2 IRR.