Question

Make sure to show the formulas and excel calculations.

Make sure to use the conventional NPV Analysis and there can be a good and bad result for this investment.

The probability of a successful project (or pilot) is now 70% and the probability of an unsuccessful project is 30%.

The Good Result: The Free Cash flow perpetuity (Annual Benefits) in the “good” case is $15 million per year and the Bad Result: The system proves to be more difficult to implement and improvements in management of the supply chain are less.

The growth in market demand for the product is lower. The Free Cash flow perpetuity

(Annual Benefits) in the "bad" case is now $1.5 million per year, not $2 million.

Given: Year 0 (currently) cash flows: $-100 million for ERP purchase and implementation.

Using traditional "all or nothing" NPV analysis, calculate the expected NPV of the project. Decide if you will invest. The cost of capital is (0.1).

Show the excel calculation and formula of the PV of the “good” perpetuity and the PV of the “bad” perpetuity.

Show the excel calculation and formula of the “good” NPV and the “bad” NPV.

Show the excel calculation and formula for the expected NPV and decide if you will invest.

Answer 1

PV of the good perpetuity = Annual amount that will continue till perpetuity/cost of capital = $15 million/0.1 = $150 million

PV of the bad perpetuity = $1.5 million/0.1 = $15 million

Good NPV = PV of good perpetuity – initial investment of purchase and implementation = 150-100 = $50 million.

Bad NPV = $15 million - $100 million = -$85 million.

Expected NPV = (probability of good perpetuity*good NPV) + (probability of bad perpetuity*bad NPV)

= 70% of $50 million + 30% of -$85 million

= $35 million - $25.50 million

= $9.5 million.

As expected NPV >0 I will invest in the project.