Topic 2 - Capital Budgeting

(a)

Digital Disruption Company is thinking about developing and marketing a new software platform for financial administration services. Upfront costs to market and develop the product are $6 million. The product is expected to generate profits of $2 million per year for 10 years. The company will have to provide product support expected to cost $100,000 per year in perpetuity. Assume all profits and expenses occur at the end of the year.

1. What is the NPV of this investment if the cost of capital is 6%? Should the firm undertake the project?

2. After having performed sensitivity analysis on a range of cost of capitals you discover that the NPV profile of this project is as depicted below. What does this graph tell us about the type of cash flows of this project, and the suitability of using either the NPV or IRR methodologies to evaluate the project?

Discount Rate D D DOO 000 2 D'DOO OOST D D DOO'00't CO DOO DOS IRR = 10.88% IRR = 2.75% WOZZ 18% 1496 10% 569 21 00 000 DOS DO DOO OOO't