Facebook is considering two proposals to overhaul its network infrastructure. Th

Question

Facebook is considering two proposals to overhaul its network infrastructure. They have received two bids. The first bid from Huawei will require a $16 million upfront investment and will generate $20 million in savings for Facebook each year for the next 33 years. The second bid from Cisco requires a $84 million upfront investment and will generate $60 million in savings each year for the next 33 years.

a. What is the IRR for Facebook associated with each bid?

b. If the cost of capital for each investment is 12%, 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 $27 million upfront, and $35 million per year for the next 33 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.) IRR for the project will be the rate at which NPV is zero i.e.

First Alternative from Huawei:

-16 + 20x{(1-(1+IRR)-33)/IRR} =0

20x{(1-(1+IRR)-33)/IRR} = 16

{(1-(1+IRR)-33)/IRR} = 0.80

Using Trial and Error Method to solve for IRR,

For IRR =0.10, LHS=9.56

For IRR =0.50, LHS=1.99

For IRR =1.00, LHS=1.00

For IRR =1.2496, LHS=0.80

Hence, the IRR for Alternative-1 is 124.96%

Second Alternative from Cisco:

-84 + 60x{(1-(1+IRR)-33)/IRR} =0

60x{(1-(1+IRR)-33)/IRR} = 84

{(1-(1+IRR)-33)/IRR} = 1.40

Using Trial and Error Method to solve for IRR,

For IRR=0.7143, LHS=1.40

Hence, the IRR for Alternative-1 is 71.43%

b.) NPV for Option-1 from Huawei = -16 + 20x{(1-(1+0.12)-33)/0.12} = -16 + 20x8.1354 = -16 + 162.71 =$146.71 mil

NPV for Option-2 from Cisco = -84 + 60x{(1-(1+0.12)-33)/0.12} = -84 + 60x8.1354 = -84 + 488.12 =$404.12 mil

c.) NPV under Lease = = -27 + (60-35)x{(1-(1+0.12)-33)/0.12} = -27 + 25x8.1354 = -27 + 203.38 =176.38

To calculate IRR, we will equate NPV to zero

-27 + (60-35)x{(1-(1+IRR)-33)/IRR} = 0

{(1-(1+IRR)-33)/IRR} = 1.08

Using Trial and Error Method,

IRR = 0.9256

Hence, IRR under lease contract =92.56%

d.) Yes, the deal under lease is better as it helps in improving the IRR figures from the project. Moreover, Facebook will not have to take out the sudden cash outflow upfront. It can keep on paying each year in installments under lease.

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