$2.$ Financial appraisal of investment projects

The NextGen project is an example of how the financial appraisal of an investment project is conducted at Cengage Learning. The NextGen project passed through several stages of the capital investment process, which required the finance team to evaluate if and to what extent the project would drive incremental revenue or contribute toward revenue preservation.

Instructions: Review the following stages of the financial appraisal process for this project and complete missing information as needed.

Project Overview

The innovation team proposed a digital learning platform that will create a personalized learning experience for each student. The platform consists of a set of flexible tools that will allow students to customize the technology to suit their personal learning needs. The executive team believes that the value proposition offered by the NextGen project will be one of a kind in the digital learning space and give the company a first$-$mover advantage. The finance team conducted the financial appraisal of the project to evaluate if and to what extent the project would drive incremental revenue or contribute toward revenue preservation.

Relevant Cash Flows

The finance team scheduled a series of meetings to discuss the different aspects of the project analysis. Sanford Tassel, Senior Vice President, Finance and Operations, Dikran Yapoujian, Vice President, Finance and other members of the finance$-$decision support team held a series of discussions. Some excerpts from their discussions follow:

From: Yapoujian, Dikran

To:$$Tassel$,$ Sanford

Cc:$$Buzzard$,$ Chris; Muhleman, Purlen

Subject:$$Relevant cash flows

Attached:$$Data$.$xls

Hey Sanford,

I$$ve been working with the team to evaluate the NextGen product in the capital approval pipeline. I$$ve crafted the valuation model taking into consideration our standard underlying assumptions, the cumulative capital outlay, and the estimations of the cash flows for this long$-$term strategic initiative.

Chris and Purlen worked through the revenue estimates, accounting for the digital solutions developed, the company$$s average textbook business, and related augmented revenues through the NextGen learning platform and the overall impact on the business by accelerating the adoption of digital products in the education marketplace. It is also expected to prevent the loss of sales on the business$$s legacy products.

Here are my thoughts:

In addition to being strategic to Cengage, the project seems viable economically. The technology used in the project is evolutionary in nature, restricting us to work with a relevant time horizon of six years and to ignore any cash flows after the sixth year.

We would need to immediately approve a capital allocation of$$$$1\mathrm{.}70$ million$$to jump$-$start the project. In addition, we would need to capitalize another$$$$20\mathrm{.}5$ million$$almost equally for the next three years. These expenses will be incurred on an after$-$tax basis. The first year of the project is unlikely to bring any additional revenues, but from second year, we should see revenues increase by$$$$1\mathrm{.}800$ million. Our preliminary estimates also show revenues growing to$$$$9\mathrm{.}700$ million$$in year $2,$$$19\mathrm{.}300$ million$$in year $3,$$$22\mathrm{.}800$ million$$in year $4,$ and$$$$24\mathrm{.}600$ million$$in year $5.$

I am also attaching some information the team used for the cash flow valuation. See you later to go over the numbers.

Cheers,

Dikran

Attachment:$$Data$.$xls

$($All dollar values in millions$)$

$$

A

B

$1$

Capitalized expenses

$$20\mathrm{.}5($spread over $3$ years$)$

$2$

Non$-$cash$($depreciable$)$ expenses

$$3\mathrm{.}400$

$3$

Operating costs as a percentage of revenues

Year $1$: $141\%$

Year $2$: $33\%$

Year $3$: $22\%$

Year $4$: $22\%$

Year $5$: $24\%$

$4$

Taxes

$40\%$

The analysts on the team created pro forma estimates of the expected cash flows that the project is likely to generate and also discussed some assumptions:

$$

Revenue estimates are based on the expectation of a higher price point resulting from a more robust product.

$$

Operating expenses include internal labor, maintenance, overhead expense, and cost avoidance from being able to ramp down spending on existing platforms.

$$

The capitalized expenses include the costs of platform development, content creation, internal and external labor, computers, facility investment, and so on$.$ These expenses are amortizable and depreciable over the first three of the six years of the project$$s expected life. They are recognized separately from the normal depreciation and amortization expenses.

$$

These capital expenses will be deducted from the project$$s annual cash flow from operations to derive at the project$$s total expected cash flows.

Complete the following cash flow analysis based on the information provided. $($Note: Express all values in millions of dollars and round all values to three decimal places. Use a minus $(-)$ sign to indicate any negative amount.$)$

Year $0$

Year $1$

Year $2$

Year $3$

Year $4$

Year $5$

Revenues

$0$

Less: Operating expenses

Less: Depreciation & Amortization

Operat