You and two friends from school (Lena and Mike) want to develop a music recommendation app for the iOS (i.e. iPhone, iPad) environment. Mike, who completed a PhD in Music, developed an algorithm that automatically codifies songs into objective criteria, such as rhythm, pace, etc. Lena, a PhD in computer science, developed an algorithm that matches consumers to these criteria. Preliminary results indicate that this algorithm can predict whether a person likes a song or not with a 92% accuracy. Your plan is to develop an iPhone app which scans a user's music library, develops a personalized 'recommended' playlist of new music every week, pushes these songs to the iPhone for people to listen to during the week, and allows for the permanent purchase/subscription of each song with a simple push of a button.

Developing the App will take about a year of time and cost $1.6 million. You are planning to make the app available for free and to earn money through a share of the revenue generated from selling/recommending music through the app with iTunes. After you release the app, you expect 40,000 people to download the app in the first month. App downloads with continue monthly, but are expected to decrease by 15% in every month thereafter (i.e. the number of downloads in a month is 85% of the number of downloads in the previous month), and you expect no further downloads after the app has been available for two years. You do, however, expect all people who download the app to continue to use the app regularly. In general, you expect Cash Flows from the app to come in for only two years after introduction, since technology and competition move very quickly in this environment. You expect that every user will generate $10 of revenue every month, but the cost of running the servers and buying the bandwidth required for your app to function amount to about $8 per user every month. Due to the risky nature of the project (and venture capital funding), the interest rate you use for calculation purposes is 18%. Note that for discounting purposes, assume all cash flows happen at the end of a year, i.e. development cost happen at the end of the first year, and all revenues/cost generated in the second and third year happen at the end of the second and third year respectively.

Part 1: Using Excel, find the net present value for this project. Discuss the validity of your assumptions and the validity of the data that is being provided.

Part 2: Building on all the info from theprevious problem, a fellow student points to a significant downside risk: during the year of development, a competitor may launch a similar service. You estimate the chance of this happening to be 30%, and the impact would be strongly decreased downloads of your app to 5,000 in the first month. How does this risk affect your (now expected) net present value? Draw or graph your Decision Tree Analysis, then submit it here. Calculate the new NPV.