Question

You are CEO of Rivet Networks, maker of ultra-high performance network cards for gaming computers, and you are considering whether to launch a new product. The product, the Killer X3000, will cost $907,000 to develop up front (year 0), and you expect revenues the first year of $803,000, growing to $1.44 million the second year, and then declining by 45% per year for the next 3 years before the product is fully obsolete. In years 1 through 5, you will have fixed costs associated with the product of $102,000 per year, and variable costs equal to 50% of revenues. a. What are the cash flows for the project in years 0 through 5? b. Plot the NPV profile for this investment using discount rates from 0% to 40% in 10% increments. c. What is the project's NPV if the project's cost of capital is 10.3%? d. Use the NPV profile to estimate the cost of capital at which the project would become unprofitable; that is, estimate the project's IRR. a. What are the cash flows for the project in years 0 through 5? Calculate the cash flows below: (Round to the nearest dollar.) Revenues $ 0 $ 803,000 YOY growth 50% Variable costs % of sales Fixed costs Investment Total cash flows (907,000) (907,000)

Answer 1

a) Calculation of cashflows from year 0 to 5

Particulars	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Revenues ($)		803000	1440000	792000	435600	239580
YOY growth				(144000 x 55%)	(792000 x 55%)	(435600 x 55%)
Variable Cost		(401500)	(720000)	(396000)	(217800)	(119790)
% of sales		(803000 x 50%)	(1440000 x 50%)	(792000 x 50%)	(435600 x 50%)	(239580 x 50%
Fixed Cost		(102000)	(102000)	(102000)	(102000)	(102000)
Investment	(907000)
Taxes		0	0	0	0	0
Net Cash flows	(907000)	299500	618000	294000	115800	17790

b) NPV profiles from 0% to 40% in 10% increments

Particulars	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Net Cash flows	(907000)	299500	618000	294000	115800	17790
PVF @ 10%	1	0.909	0.826	0.751	0.683	0.621
Present Value	(907000)	272246	510468	220794	79091	11048
PVF @ 20%	1	0.833	0.694	0.579	0.482	0.402
Present Value	(907000)	249484	428892	170226	55816	7152
PVF @ 30%	1	0.769	0.592	0.455	0.350	0.269
Present Value	(907000)	230316	365856	133770	40530	4786
PVF @ 40%	1	0.714	0.510	0.364	0.260	0.186

Present Value

(907000)

213843

315180

107016

30108

3309

NPV (if discount rate is 10%) = 186647

NPV (if discount rate is 20%) = 4570

NPV (if discount rate is 30%) = -131742

NPV (if discount rate is 40%) = -237544

c) Project's NPV if Project's cost of capital is 10.30%

Particulars	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Net Cash flows	(907000)	299500	618000	294000	115800	17790
PVF @ 10.3%	1	0.907	0.822	0.745	0.676	0.612
Present Value	(907000)	271646	507996	219030	78281	10887

NPV (if discount rate is 10.3%) = 180840

d) Estimation of internal rate of return

We will follow the hit and trial method to estimate the IRR

Let IRR be 20%

As could be seen from part (b) of the question, NPV will be +4570

Let IRR be 30%

As could be seen from part (b) of the question, NPV will be -131742

Now applying the hit and trial method, we have the following formula to estimate the IRR.

IRR = lower rate + lower rate NPV / (Lower rate NPV - Higher rate NPV) x (higher rate - lower rate)

IRR = 20% + 4570 / 4570 - (-131742) x (30% - 20%)

IRR = 20.34%