Your company has spent $250,000 on research to develop a new computer game. The
ID: 2642504 • Letter: Y
Question
Your company has spent $250,000 on research to develop a new computer game. The firm is planning to spend $1,400,000 on a machine to produce the new game. Shipping and installation costs for the new machine total $200,000 and these costs will be capitalized and depreciated together with the cost of the machine. The machine will be used for 3 years, has a $200,000 estimated resale value at the end of three years, and will be depreciated straight line over 4 years. Revenue from the new game is expected to be $1,200,000 per year, with costs of $500,000 per year. The firm has a tax rate of 35 percent, a cost of capital (discount rate) of 6 percent, and it expects net working capital (NWC) to increase by $150,000 at the beginning of the project. This investment in NWC will be wholly recouped at the end of the project. .
Complete the table below.
In the second table below calculate the Net Present Value (NPV) of the project.
Calculate the Profitability Index (PI) of the project.
Is the Internal Rate of Return (IRR) of the project greater than, equal to, or less than the cost of capital (discount rate)?
Should your company proceed with this project? Explain based on the decision criteria for NPV, PI, and IRR.
Year
0
1
2
3
Revenue
Costs
Depreciation
EBIT
Taxes
Net Income
Operating Cash Flow
Change in Net Operating Working Capital
Change in Gross Fixed Assets
Total Free Cash Flow
Net Present Value
Profitability Index
Internal Rate of Return >, =, or < the cost of capital (discount rate)?
Proceed with the project? Explain.
Year
0
1
2
3
Revenue
Costs
Depreciation
EBIT
Taxes
Net Income
Operating Cash Flow
Change in Net Operating Working Capital
Change in Gross Fixed Assets
Total Free Cash Flow
Explanation / Answer
Cost of the machine = $1,400,000----------------(A)
Cost of shipping and installation= $200,000---------------(B)
Total cost to be capitalized = A+B = $1,600,000.
Cash ouflow on account of increase in net working captial = 150,000
The asset to be depreciated over a period of 4 years.
Depreciation = 1,600,000/4 = $400,000
Formula for Net Present value= Discounted cash outflows - Discounted cash inflows.
Formula for profitablity index = Present value of cash inflows/Present value of cash outflows
IRR is the rate at which the Project NPV is equal to zero
Calculation of Profitability index = Present of cash inflows/Present value of cash outflows = $2,135,000/$1,750,000 =1.22
Calculation of IRR:
Interpolating cash flows between 9% and 10%
IRR = 9% + 26384.54/(26384.54 + 7362.89)
IRR = 9% +0.78=9.78%
Yes, the company should proceed with the project as the net present value of the project is positive and the IRR of the project is also much higher than the cost of capital.
Note: The research cost is not conisdered for the calculation as it is an incurred cost.
Particulars 0 1 2 3 Revenue $ 1,200,000.00 $ 1,200,000.00 $ 1,200,000.00 Costs $ (1,600,000.00) $ 500,000.00 $ 500,000.00 $ 500,000.00 Depreciation 400000 400000 400000 EBIT $ 300,000.00 $ 300,000.00 $ 300,000.00 Taxes (35%) $ 105,000.00 $ 105,000.00 $ 105,000.00 Net income $ 195,000.00 $ 195,000.00 $ 195,000.00 Operating cash flows $ 595,000.00 $ 595,000.00 $ 595,000.00 Change in net working capital $ (150,000.00) $ 150,000.00 Change in gross fixed assets $ 200,000.00 Total free Cash flows $ (1,750,000.00) $ 595,000.00 $ 595,000.00 $ 945,000.00 Net Present value $ 134,308.86 Profitability index 1.22 IRR of the project 9.78%Related Questions
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