Calculation Of Profitability Index, Net Present Value And Internal Rate Of Return For A New Project

Question

Case

Annoy-Tones Ltd is a mobile phone content provider located in South Melbourne. They presently sell mobile phone applications, delivery of content by SMS and ring tones. The company posted a pre-tax profit of $5 million in 2009. A recent survey has found the consumer market for ring tones has dropped by 30% in the last 2 years. It is expected the drop in sales will be between 20% - 25% each year in the next 2 years. Some of the main reasons for this decline include: working mobile phone users are finding ring tones “too cheesy”; newer generation of mobile phone users are able to customize ringing tones themselves; and the bad image associated with mobile content vendors over the last few years.

Mrowkoob who is the manager for the product development team has asked Dren Ti to consider investing in a new dedicated server that will allow the company to provide reverse ring tones. These outbound ring tone services cannot be customized by mobile users. Another advantage of this service is content buyers do not have to worry about embarrassing moments such as when the phone rings during a formal occasion as it will only be heard by the caller and still be able to achieve the desired social attention.

Annoy-Tones Ltd believe the idea is worth exploring and have paid $AUD20,000 to a market research firm to investigate the viability of this project. The market research firm has also recommended Annoy-Tones Ltd to sign another consulting project valued at $AUD25,000 to review the training needs of staff managing the new server, if the project is approved. The new server will be purchased from the United States for $USD200,000. Given the current exchange rates, the server would cost $AUD220,000 and a further $AUD30,000 to complete installation. The server is expected to have a five-year useful life and will be depreciated accordingly.

The company plans to name this project “Richie RI”. To create awareness of this service would require the company to spend $AUD150,000 straight away for marketing and a further $AUD50,000 in the third year of operations. The General Manager also believes that a working capital injection of $AUD65,000 would be required, but it is anticipated that 80% of the working capital could be recouped at the end of the project. The server can be fully depreciated equally at the total cost over the five years for taxation purposes.

A major hardware upgrade of the server would be required at the end of year 3 which will cost $AUD250,000 while a software update would be required at the beginning of year 3.  This is expected to cost $AUD50,000. The upgrade of the server is not expected to have any substantial impact on production. Both the service and software are needed to ensure the equipment remains productive until the end of year 5. Early discussions with the company’s management accountant is that these costs are tax deductible and can be written off as the operating expenditure in a single year, until the end of the project.

The company plans to charge subscribers $AUD5 a month. By diverting the subscriber’s call through the company server, the development team has worked out that the company’s internet provider will charge the company roughly $AUD3.50 per subscriber per month. Fixed costs (not including depreciation) to the overall company expense would amount to $AUD120,000 per year. The company has forecasted the following number of subscribers:

Year 1: 15,000
Year 2: 25,000
Year 3: 22,000
Year 4: 18,000
Year 5: 13,000

Company tax rate is currently set at 30%. Despite the current political instability, it is assumed that company tax rates will be reduced to 28% in 2 years time. Their cost of capital of the firm is 15% at the moment. After discussions with other staff members, the accountant has come to the conclusion that the server is likely to have a resale value of $30,000 at the end of the five years.

Part 1

You are working under the Chief Financial Officer who requires you to do the following:

(a) Calculate, showing all workings:
i. The net present value of the investment.
ii. The undiscounted and discounted payback period of the investment.
iii. The internal rate of return of the project to two decimal places.
iv. The profitability index for the investment.

(b) Write a memo to Dren Ti, CEO of the firm advising him (no more than 300 words) of the following:

i. Whether the company should proceed with the investment, giving reasons for your decision.
ii. Discuss and highlight some of the possible risks and your estimates. Your memo should be written in memo form, and be written specifically to Dren Ti who has no formal training in accounting or finance. The memo should not present your calculations and the method by which they were obtained. Instead your memo should focus on the relevance of your results and what issues it raises for the company in making a decision regarding the benefit of this investment to the company.

Part 2

(a) The company wishes to investigate the option of providing varying inverse ring tones, code named as “Richie RII” in year 3.  Subscribers would be allowed to have their outbound ring tone subscription updated automatically. Subscribers could preset their reverse ring tone as the songs from the American-top-40 pop chart or theme songs from current reality TV shows shown on Channel-X.

This new service is planned to be offered to subscribers at $8 a month. The manager expects the following number of subscribers (instead of the previous scenario, in Part 1) to “Richie RII” to be:

Year 3: 9,500
Year 4: 7,000
Year 5: 6,000

“Richie RII” is expected to cost the company an additional $AUD25,000 in R&D during year two. Subsequently it is expected “Richie RII” will also lead to a drop in sales for “Richie RI” by 15% over the three year period.  What is the new scenario given this new information. Hint: refer to section 1a.

(b) A senior colleague with an engineering background has questioned your approach. He thinks it is too simplistic. You recently came across the article by Farragher, Klieman and Sadu (2001) “The Association between the Use of Sophisticated Capital Budgeting practices and Corporate Performance.  Write a memo to your senior colleague, explaining the approach you have undertaken.

Required: prepare a memo of no more than 500 words to justify your approach.

Summary

The question belongs to Finance. This is a case scenario about Annoy-Tones Ltd, a mobile phone content provider located in South Melbourne. The company wants to start a new venture named Richie RI and wants to calculate the projected net present value, undiscounted and discounted payback period, the internal rate of return and the profitability index and to write a memo to the CEO of the company advising him on the investment.

Total Word Count 192

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