1. An online DVD and CD retailer is considering investing $2m on improving its c

Question

1. An online DVD and CD retailer is considering investing $2m on improving its customer information and online ordering systems. The expectation is that this will enable the company to expand by extending its range of products. A decision will be made on the expansion in 1 year's time, when the directors have had chance to analyse customer behaviour and competitors' businesses in more detail, to assess whether the expansion is worthwhile. Preliminary estimates of the expansion programme have found that an j investment of $5m in 1 year's time will generate net receipts with a present value of $4m in the years thereafter. The project's cash flows are expected to be quite volatile, with a standard deviation of 40%. The current risk free rate of interest is 5%. Required: Advise the firm whether the initial investment in updating the systems is worthwhile.

Explanation / Answer

Yes..

Prelimnary Investment Decision Current Investment Intial Investment outflow ($5,000,000) ($2,000,000) Risk free interest rate 5% PV of cashflow $4,000,000       =$2000000/(1+0.05) $1,904,762 Valatility Stad. Devaition 40% 40% Variance (Std.Dev)^2 16% 16% Cashflow Volaltility $640,000 $304,762 Cash flow vol/ Cash inflow                =$5000000/$6400000 =$304,762/$6400000 13%                   < 15% Initial investment giving 15%cashflow with volatility which is grether than the prelimnary investment

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