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

1.

The firm’s initial investment in updating the systems would be worthwhile only if the present value of the future cash inflows is more than the initial investment in the year 0.

As per the preliminary estimates, the net present value of the project at the discount interest rate of as low as 5% is going to negative. Moreover, the standard deviation of the cash flows is very high at the level of 40%, which makes the initializing the project a risky one.

So, the directors must have to analyse customer behavior and competitors’ businesses in more detail towards the desired interest rates and deviations in the returns on the investment.

Thus, going with the preliminary estimates, it is not worthwhile to have investment in updating the systems.

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