Your company has spent $200,000 on research to develop a new computer game

Whether the project should be pursued depends on the whether you take into account the sunk cost of research expenditure. If you include this expenditure, then the net present value (NPV) is negative and the project should not be pursued. However, ignoring the research expenditure, since it has already been spent, this product would produce positive NPV. In that case, it should be pursued.

In order to figure out whether to proceed with the project, we need to compute the net present value provided by the new game and see whether it is above or below zero. If it is above zero, you can proceed with the project; if it is below zero, you should not proceed with the project.

• The profit from selling the game each year = $400,000 - $150,000 = $250,000
• Cost of the machine = $300,000
• Resale value = $50,000
• The machine has an expected life of 3 years; therefore, the project has to provide sufficient return in 3 years.
• Shipping and installation costs = $25,000

The machine and installation costs (basis) of $325,000 are depreciated over a 7 year period using MACRS-7 table. We assume 200% declining balance method and half-year convention. Then we compute depreciation for the years 1 through 7 as:

• Basis: $325,000
• Date Placed In Service: January of 2018
• Recovery Period: 7 Years
• Depreciation Method: 200% Declining Balance Method
• IRS Convention: Half-Year Convention

MACRS 7-Year Depreciation Schedule

Next, we proceed to compute the free cash flow that will result in each year of this project. The investment expenses are shown under year 0. The gross profit is first computed by subtracting the cost of goods sold from sales revenue.

Then, we compute net operating income by subtracting the depreciation from the gross profit. The income tax is then computed on the net operating income. We compute the net income by subtracting the income tax from the net operating income.

We add back the depreciation (since this is only an amount used to compute net operating income; there is no cash flow) in order to figure out free cash flow amount for each year.

Present Value is computed by the following formula..

PV=FV/(1+r)nPV=FV/(1+r)n

• PV is Present Value
• FV is Future Value
• r is the interest rate (as a decimal, so 0.10, not 10%)
• n is the number of years

Present Value for Year 1 = $178,750 / 1.1 = $162,500

Present Value for year 2 = $190,357 / (1.1 * 1.1) = $157,319.84

Present Value for Year 3 = $214,901 / (1.1 * 1.1 * 1.1) = $161,458.30

PV of Expected Cash flows = $162,500 + $157,319.84 + $161,458.30 = $481,278.14

Net Present Value is the difference between the present value of cash inflows and the present value of cash outflows.

Net Present Value = -$600,000 + $481,278.14 = -$118,721.86

With a discount rate of 10.00% and a span of 3 years, your projected cash flows are worth $481,278.14 today, which is less than the initial $600,000.00 paid in order to begin. The resulting NPV of the above project is -$118,721.86, which means you will not receive the required return at the end of the project. Therefore, pursuing the above project may not be an optimal decision.

However, the decision may change if you consider that the company has already spent $200,000 in research expenses; this is sunk cost and cannot be recaptured. Therefore, it is possible to consider the investment on the game to be only $400,000 (cost of machine + installation cost + increase in working capital). Then, we compute the net present value.

PV of Expected Cash flows: $481,278.14

Net Present Value: -$400,000 + $481,278.14 = $81,278.14

With a discount rate of 10.00% and a span of 3 years, your projected cash flows are worth $481,278.14 today, which is greater than the initial $400,000.00 paid. The resulting positive NPV of the above project is $81,278.14, which indicates that pursuing the above project may be optimal.

You can tell management that the computations will change as the game is sold and the actual revenues and expenses are figured out each year. Since the game market is on the upswing, this product might provide the needed entry to the market for your company. Therefore, even though the initial computations show that the NPV is negative for this project, ignoring the research expenditure, this product would produce positive NPV. Therefore, it should be pursued.