Question

Your firm has been hired to develop new software for the university's class registration system. Under the contract, you will receive $494,000 as an upfront payment. You expect the development costs to be $445,000 per year for the next 3 years. Once the new system is in place, you will receive a final payment of $881,000 from the university 4 years from now.

a. If your cost of capital is 10%, is the opportunity attractive?
b. What are the IRRS of this opportunity?
Suppose you are able to renegotiate the terms of the contract so that your final payment in year 4 will be $1.2 million.
c. What is the IRR of the opportunity now? d. Is it attractive at the new terms?
d. What are the IRRs of this opportunity? (Hint: Build an Excel model which

Answer 1

The opportunity is attractive with an NPV of $46,036 and an IRR of 15.49%. After renegotiating the contract, the opportunity remains attractive with an NPV of $540,188 and an IRR of 18.95%.

Step-by-step explanation:

a. To determine if the opportunity is attractive, we need to calculate the net present value (NPV) of the project. NPV is calculated by discounting the future cash flows at the cost of capital. In this case, the upfront payment of $494,000 and the development costs of $445,000 per year for 3 years are negative cash flows, while the final payment of $881,000 is a positive cash flow. Using a discount rate of 10%, we can calculate the NPV:

NPV = -494,000 - 445,000/(1 + 0.10) + 445,000/(1 + 0.10)^2 + 445,000/(1 + 0.10)^3 + 881,000/(1 + 0.10)^4

Solving this equation, the NPV is approximately $46,036. Since the NPV is positive, the opportunity is attractive.

b. The internal rate of return (IRR) is the discount rate that results in a zero NPV. To calculate the IRR, we need to find the discount rate that makes the NPV equal to zero. We can use Excel or other software to calculate the IRR:

IRR = 15.49%

Therefore, the IRR of this opportunity is approximately 15.49%.

c. If we renegotiate the terms of the contract and the final payment in year 4 becomes $1.2 million, we need to recalculate the NPV and IRR. The NPV is now:

NPV = -494,000 - 445,000/(1 + 0.10) + 445,000/(1 + 0.10)^2 + 445,000/(1 + 0.10)^3 + 1,200,000/(1 + 0.10)^4

The new NPV is approximately $540,188. It is still positive, indicating that the opportunity is still attractive.

The new IRR is calculated as:

IRR = 18.95%

Therefore, the new IRR of this opportunity is approximately 18.95%.

d. The terms of the contract have been renegotiated, and the new final payment is $1.2 million. The new NPV is positive ($540,188), indicating that the opportunity is still attractive. The new IRR is approximately 18.95%, which is higher than the cost of capital (10%), further supporting the attractiveness of the opportunity.