Problem
As a senior analyst for Lawton Enterprise, you have been asked to evaluate a new computer hardware project with the following characteristics:
1. Acquiring a computer hardware for a cost of $2,000,000.
2. The computer hardware has an expected five-year life.
3. The initial investment in net working capital (in Year 0) is $200,000. The investment in working capital is to be completely recovered by the end of the project's life (in Year 5).
4. The computer hardware can be depreciated on a straight-line (prime cost) basis and there is no expected salvage value after the five years.
5. The produced software is expected to generate sales of $1,250,000 in Year 1. They grow at a 25% annual rate for the next two years, and then grow at a 10% annual rate for the last two years.
6. Fixed operating expenses are $100,000 for Years 1-3 and $110,000 for Years 4-5.
7. Variable operating expenses are 20% of sales in Years 1-2 and 25% of sales in Years 3-5.
8. Lawton does not have any available space where the project can be located for five years and you anticipate to rent the required office space it would cost $65,000 per year for the life of the project. You expect that the project will need to hire three new software specialists at $50,000 (each specialist) per year (start in Year 1) for the full five years to work on the software.
9. The project will use a van currently owned by Lawton. Although the van is not currently being used by Lawton, it can be rented out for $15,000 per year for five years. The book value of the van is $20,000. The van is being depreciated straight-line (with five years remaining for depreciation) and is expected to be worthless after the five years.
10. Lawton's marginal tax rate is 30%, and the discount rate is 12%.
Based on the information presented above, answer the following questions:
A. Calculate the incremental free cash flow during the project's life (starting from Year 0 to Year 5). Show workings.
B. Calculate the NPV, payback period and IRR of the project. Should the project be accepted?