AOL is considering two proposals to overhaul its network infrastructure. They ha

Question

AOL is considering two proposals to overhaul its network infrastructure. They have received two bids. The first bid from Huawei will require a $18 million upfront investment and will generate $20 million in savings for AOL. Each year for the next 3 years. The second bid from CIsco requires a $96 million upfront investment and will generate $60 million in savings each year for the next 3 years. a. what is the IRR for AOL associated with each bid? b. if the cost of capital for each investment is 10% what is the next present value (NPV) for each bid? Suppose cisco modifies is bid by offering a lease contract instead. Under the terms of the lease, AOL, will pay $26 million upfront, and $35 million per year for the next 3 years. AOL's savings will be the same as with Ciscos original bid. c. what is the IRR of the Cisco bid now? d. what is the new NPV? e. What should AOL do?

Explanation / Answer

Computation of NPV and IRR of first bid from Huawei: Year Cash flow DF @ 10% DCF DF @ 30 % DCF 1 20 0.909 18.18 0.769 15.38 2 20 0.826 16.52 0.592 11.84 3 20 0.751 15.02 0.455 9.1 total 60 49.72 36.32 0 ( Initial Investment) 18 1 18 1 18 NPV: 42 31.72 18.32 Lower rate %+ Lower rate NPV * Difference in rate IRR = Lower rate NPV- Higher rate NPV = 10%+ 31.72 * 20% 31.72-18.32 On solving , we get IRR = 10.47% Computation of NPV and IRR of second bid from Cisco: Year Cash flow DF @ 10% DCF DF @ 30 % DCF 1 60 0.909 54.54 0.769 46.14 2 60 0.826 49.56 0.592 35.52 3 60 0.751 45.06 0.455 27.3 total 180 149.16 108.96 0 ( Initial Investment) 96 1 96 1 96 NPV: 84 53.16 12.96 Lower rate %+ Lower rate NPV * Difference in rate IRR = Lower rate NPV- Higher rate NPV = 10%+ 53.16 * 20% 53.16-12.96 On solving , we get IRR = 10.26% Computation of NPV and IRR of second bid from Cisco under lease contract : Year Savings DF @ 10% DCF DF @ 30 % DCF 1 25 0.909 22.725 0.769 19.225 2 25 0.826 20.65 0.592 14.8 3 25 0.751 18.775 0.455 11.375 total 75 62.15 45.4 0 ( Initial Investment) 26 1 26 1 26 NPV: 49 36.15 19.4 Lower rate %+ Lower rate NPV * Difference in rate IRR = Lower rate NPV- Higher rate NPV = 10%+ 36.15 * 20% 36.15-19.4 On solving , we get IRR = 10.43% Conclusion: Based on NPV , AOL should consider bid proposal of Cisco, since the NPV is higher when compared with the first bid or Lease contract.

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