4. You are contemplating customizing a wireless tablet computer to be bundled with application software and sold into a specific vertical market. This bundling and customization involves some minor hardware modifications but more significant software development. To accomplish the software modifications needed you can either do the work yourself ('in house') or license the software from another company that has done similar work for another brand of tablet. Doing it in house will take longer to get to market but the software will be more robust and likely will result in higher sales. Here is a summary of the sales of the two alternatives:

In house License

Year 1 250,000 1,000,000
Year 2 3,000,000 1,500,000
Year 3 3,500,000 2,500,000
Year 4 2,200,000 2,000,000
Year 5 1,400,000 1,200,000
Year 6 700,000 500,000
Year 7 0 0


The license fee will be 5% of sales (treat this like an R&D expense on the income statement) but there are no other incremental development expenses, initial royalty payments, or investments.

The in house option will require a $500,000 initial investment in development equipment which can be depreciated over a five year useful life. This option will also require engineering expenses of $300,000 incurred and paid in year 1.

Under either alternative, cost of goods sold will be 40% of sales, and Sales/G&A expenses will be 15% of sales. Accounts Receivable and Inventory will have to be funded equal to 20% of the projected sales of the following year. The marginal tax rate is 40% and the cost of capital is 20%.

a. What are the free cash flows of this project for the license alternative?
b. What are the free cash flows of this project if internally developed?
c. Would you license or develop internally? Why?
d. Approximately what is the highest royalty rate you would pay? Explain.