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

$ 25$25

million upfront investment and will generate

$ 20$20

million in savings for Facebook each year for the next

33

years. The second bid from Cisco requires a

$ 85$85

million upfront investment and will generate

$ 60$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

18 %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

$ 26$26

million upfront, and

$ 35$35

million per year for the next

33

years. Facebook's savings will be the same as withCisco'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

Huawei Cisco Upfront investment 25 85 Savings 20 60 Time (Years) 33 33 (i) IRR - if we discount cash flows @ IRR NPV = 0 (a) Huawei NPV = 20 x PVAF(r,33) - 25 =0 PVAF(r,33) = 25/20 PVAF(r,33) = 1.25 From PV table r = 80% (b) Cisco NPV = 60 x PVAF(r,33) - 85 =0 PVAF(r,33) = 85/60 PVAF(r,33) = 1.416667 r PVAF 70 1.4286 r 1.4167 71 1.4085 Using linear interpolation - r-70/71-70 = (1.4167-1.4286)/(1.4085-1.4286) r-70 = 0.591665 r = 0.59167 + 70 r = 70.59167 (ii) Huawei Cisco Upfront investment 25 85 Savings 20 60 Time (Years) 33 33 Cost of capital 18% 18% PVAF(18%,33) 5.5320 5.5320 PV of annual savings 110.63943 331.9183 Initial investment -25 -85 NPV 85.639427 246.9183 (iii) Upfront investment 26 Savings 60 Less: annual lease 35 Net cash flow 25 Time 33 NPV = 25 x PVAF(r,33) - 26 =0 PVAF(r,33) = 26/25 PVAF(r,33) = 1.040 r PVAF 96 1.0417 r 1.0400 97 1.0309 Using linear interpolation - r-96/97-96 = (1.04 -1.0417)/(1.0309) r-96= 0.1552 r = 96 + 0.1552 r = 96.1552 (iv) As per IRR analysis the new bid is better as it will result in higher return, But if we see closly the annual cash flows are reduced if we calculate NPV of the new bid it is - Also NPV = 25 x PVAF(18%,33) - 26 = 5.5320 x 25 -26 = 138.2993 -26 112.2993 Which is way too low then the existing bid. The new bid will result in lower cashflows. New bid is not acceptable Please provide feedback…. Thanks in advance…. :-)

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