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 ten 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 11%.

b. How many IRRs does this investment opportunity have?

c. What does the IRR rule indicate about this investment?

Answer 1

We use pv formaule in excel to find the present value of costs

NPV= -initial investment+present value of profits-present value of support costs

present value of profits: =pv(rate,nper,pmt,fv,type)

=pv(6%,10,1000000,0,0)=7360087.05

present value of support costs= 100000/6%=1666666.67

NPV=(-5*10^6)+7360087.05-1666666.67

=693420.38

Since NPV is positive they should accept.

If i=2%

NPV=(-5*10^6)+pv(2%,10,-1000000,0,0)-(100000/2%)

=-1017414.99 here we should not accept since npv is negative

if i=11%

NPV=(-5*10^6)+pv(11%,10,-1000000,0,0)-(100000/11%)

=-19858.90 here we should not accept since npv is negative

b)It will have 2 IRR since there is sign chnage twice

c)If the IRR is higher than cost of capital then we should go ahead with the investment