Problem 5. Incremental Cash Flow: In-House v. Licensing

Chips Inc. is contemplating improving its longstanding flagship memory chip. It has two options that Chips Inc. is contemplating today (time 0):

Continue with the current In-House R&D activity. Operating costs are $5.0 million for each of the next five years these costs do not include the R&D costs, and the costs are incurred at the end of each year. If Chips Inc. goes on with the in-house option it will take two years from today to get the new chip to market so the estimate is that the new improved chip will make sales of $1.5 million per year for four years (time 2, 3, 4, and 5). The revenue is received at the end of each year.

Switch to a License Option immediately by which it pays AMP Rad Inc. a yearly license of $1 million paid at the end of each of the following five years. The license agreement gives Chips Inc. access to AMP Rad Inc. intellectual property (IP) allowing Chips Inc. to update its chip to the new version much faster: Chips Inc. will be able to bring to the market the new improved memory chip in a one year time from today and have sales for of $2 million per year for each of the next five years (time 1, 2, 3, 4, and 5). This switch will decrease Chips Inc.s operating costs by $1.0 million per year for the next five years and, additionally, will allow Chips Inc. to save on R&D costs an amount of $0.5 million per year for the next five years. All costs and revenues are incurred at the end of each year.

No machinery is bought/sold, no depreciation that needs to be accounted for, and no net working capital is necessary for either of the two options. Additional information: income tax rate is 20.00%.

a. Calculate the Incremental Cash Flow for switching from In-House Option to License Option.

b. If the opportunity cost of capital is 10% what is the NPV for the switching from In-House Option to License Option?