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As a senior analyst for the company you have been asked toevaluate a new IT software project. The company has just paid aconsulting firm $50,000 for a test marketing analysis. Afterlooking at the project plan, you anticipate that the project willneed to acquire computer hardware for a cost of $400,000. TheAustralian Taxation Office rules allow an effective life for thecomputer hardware of five years. The equipment can be depreciatedon a straight-line (prime cost) basis and there is no expectedsalvage value after the five years.
Your company does not have any available space where the projectcan be located for five years and you anticipate a new office willcost $80,000 to rent for the first year. You expect that theproject will need to hire 3 new software specialists at $50,000(each specialist) in the first year for the full five years to workon the software.
The project will use a van currently owned by the company andalthough the van is not currently being used by the company, it canbe rented out for $5,000 per year for five years. The book value ofthe van is $20,000. The van is being depreciated straight-line(with five years remaining for depreciation) and is expected to beworthless after the five years.
Expected annual marketing and selling costs will be incurred,with the first year expecting to be $200,000. The produced softwareis expected to sell at $100 per unit while the cost to produce eachunit is $40. You expect that 10,000 units will be sold in the firstyear and the number of units sold will increase by 20% a year forthe remaining four years. The project will need working capital of$50 000 to commence the business (in year 0) and the investment inworking capital is to be completely recovered by the end of theproject’s life (in year 5). The company tax rate is 30%, and thediscount rate is 10%.
Based on the information presented above, answer the followingquestions (1) – (3).
1. In evaluating the new IT software project, are thecost of $50,000 spent on marketing analysis and the use of vanrelevant for capital budgeting decision? Explain youranswer(s).
2. Calculate the incremental free cash flow duringthe project’s life (at the end of Years 1 through 5). Showworkings.
3. Calculate the NPV, payback period and IRR of theproject. Should the project be accepted? Show workings and explainyour answer(s).
