Consider a new video game developed by Dynamic Gaming Innovations (DGI). DGI’s development team was formed at the end of 2006 and has been working on the development of the game for several years. After spending €175,000 on the development, the team has reached the point in 2010 where it must make a decision on whether to proceed with production of the game. Production of the game will require an initial investment in facilities of €199,500 at the end of 2010. The project has an expected life cycle of 7 years (end of 2010 through 2017).

Predicted cash flows for the game are as follows (assuming that all cash flows occur at the end of the year):

DGI’s applicable tax rate is 40 per cent and DGI uses straight-line depreciation over the asset’s expected life for tax purposes. The salvage value of the facilities will be zero in 7 years.

DGI uses two criteria to evaluate potential investments: payback time and NPV. It wants a payback period of 3 years or less and an NPV greater than zero. DGI has a cost of capital of 18 per cent.

1. Prepare a table that shows the after-tax annual net cash flows, cumulative net cash flow and cumulative discounted net cash flow each year.

2. Would DGI invest in production of the game if it uses the payback period?

3. Would DGI invest in production of the game if it uses the NPV model?

4. Use graph paper to prepare a well-labelled line chart that shows the cumulative after-tax net cash flow and the cumulative after-tax discounted net cash flow of this investment over its life cycle. On your chart, clearly identify the payback time and the NPV for the project.

5 Would you recommend that DGI invest in this project? Explain.

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End of year 2010 2011 2012 2013 2014 2015 2016 2017 Cash inflow € 0 100,000 220,000 340,000 460,000 470,000 410,000 150,000 Cash outflow €199,500 100,000 180,000 260,000 320,000 280,000 200,000 120,000