Facebook is considering two proposals to overhaul its network infrastructure. Th
ID: 2792875 • Letter: F
Question
Facebook is considering two proposals to overhaul its network infrastructure. They have received two bids. The first bid from Huawei will require a $15 million upfront investment and will generate $20 million in savings for Facebook each year for the next 3 years. The second bid from Cisco requires a $89 million upfront investment and will generate $60 million in savings each year for the next 3 years.
a. What is the IRR for Facebook associated with each bid?
b. If the cost of capital for each investment is 18%, what is the net present value (NPV) for Facebook of each bid?
Suppose Cisco modifies its bid by offering a lease contract instead. Under the terms of the lease, Facebook will pay $30 million upfront, and $35 million per year for the next 3 years. Facebook's savings will be the same as with Cisco's original bid.
c. Including its savings, what are Facebook's net cash flow under the lease contract? What is the IRR of the Cisco bid now?
d. Is this new bid a better deal for Facebook than Cisco's original bid? Explain.
Explanation / Answer
a&b
NPV for Huawei bid=-15+20/(1+r)+20/(1+r)^2+20/(1+r)^3
=-15+20/(1+18%)+20/(1+18%)^2+20/(1+18%)^3
=28.48546 million
IRR is the rate at which NPV=0
=>0=-15+20/(1+r)+20/(1+r)^2+20/(1+r)^3
=>r=120.98%
So, IRR for Huawei bid=120.98%
NPV for Cisco bid=-89+60/(1+r)+60/(1+r)^2+60/(1+r)^3
=-89+60/(1+18%)+60/(1+18%)^2+60/(1+18%)^3
=41.45638 million
IRR is the rate at which NPV=0
=>0=-89+60/(1+r)+60/(1+r)^2+60/(1+r)^3
=>r=45.55%
So, IRR for Cisco bid=45.55%
c
NPV for Cisco bid=-30+(60-35)/(1+r)+(60-35)/(1+r)^2+(60-35)/(1+r)^3
=-30+25/(1+18%)+25/(1+18%)^2+25/(1+18%)^3
=24.35682 million
IRR is the rate at which NPV=0
=>0=-30+25/(1+r)+25/(1+r)^2+25/(1+r)^3
=>r=45.55%
So, IRR for Cisco bid=64.67%
d
This is not a better bid as NPV has decreased.Why IRR is not the correct method in this case is that the cash flows are not normal-outflow occurs even after initial investment
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