Net Present Value Analysis
1. The following are the key assumptions of used in this analysis;
- Employee cost: average salary per employee involved in implementation is 100000
- Consultation cost per month 15400 per month
2. With a NPV of (8.2) million and reduced average consulting cost per month of $ 5000 from 15400, the discount rate that will make the NPV for the project 0 is 0.026306212. This is also equivalent to 2.63%.
3. With consulting cost of $15,400 per month and a discount rate of 0.09, the NPV of the project will be $ (25.7) million if the number of employees participating in the project is increased from 200 to 400 i.e. are doubled.
4. If the consulting fee turns out to be $ 20,000 per month and the number of employees participating maintained at 200, the NPV of the project will be $ (10.1) million. This implies that an increase in consulting fee will add up to the NPV of costs and this will increase the net NPV from $ (8.2) to $ (10.1) for the six years..
5. Maintaining the consulting salary at $15,400 per month, the NPV of the project will be $ (14.4) if the number of consultants required each month is doubled. This amount is arrived at by multiplying all the consulting cost figures for all the six years by two.
6. At the original staffing levels for consultants, the estimated benefits stand at $ 46.6 million. These benefits have to be increased by more than $ 8.2 in order to be attractive given a benefits adjustment factor of 1.00.
Options Pricing Analysis
7. Whirlpool is buying an option to in order to invest in a major IT investment.
8. Given an option cost of $ 4 million and the value of the option given as $ 3 613 788, Whirlpool should abandon the project. The decision rule for projects is that they should only be implemented when the cost of the option is less than the value of the option.
9. If Whirlpool finds a way to reduce the costs of the project by 5% to 95%, the value of the option will be $ 4 765 077. Whirlpool should thus not proceed with the pilot under these costs
10. With a cost factor of 100%, the value of the option if the risk free interest rate doubles from 4% to 8% will be $ 4 495 834. The value of the option increases from $ 3 613 788 to $ 4 495 834 if the risk free rate is doubled. This implies that changes in the risk free interest rate are positively related to the value of the option holding other factors constant.
11. With the risk free rate of 4%, the value of the option if Whirlpool’s cost of capital goes up from 9% to 15% will be $ 2 812 116. The value of the option declines from $ 3 613 788 to $ 2 812 116 as the cost of capital reduces by 6%. This suggests that the cost of capital is inversely related to the value of the option holding other factors constant.
12. With a cost of capital given as 9%, Sigma squared as the variance in the rate of return of the project, and the range surrounding the expected returns, which starts at 20%, the worst estimate is 80% of the expected, and the best is 120% of the expected.
- If the range is changed from 20% to 10%, the value of the option is $ 1 432 615.
- If the range is increased from 20% to 30%, the value of the option is $ 5 822 517.
- Part (a) illustrates a worst case scenario where the actual returns from the project falls short of the expected returns. Part (b), on the other hand, indicates a best case scenario where the actual returns of the project increase over the expected returns of the project.
The options pricing method is highly sensitive to changes in expected returns. The IT projects should not be adopted if they exhibit high ranges from the expected returns.
13. Based on the NPV analysis, the project should be abandoned. With a negative NPV of $ (8.2) million, the project’s costs exceeds its benefits. Using Black and Scholes’ Options Price Model, the project should also be abandoned. This is because the expected revenue from conducting the pilot ($ 50 818 561) was lower than the exercise price ($ 54 851 092) by $ 4 032 531.
14. The factors that might influence the decision of Whirlpool management about investing in SAP in Europe include:
- Exercise price
- Duration of the option
- Compounded risk-free interest rate (T-bill rate)
- Standard deviation of return
15. Do not invest.
The costs of investing in the project outweigh the benefits of the project.
Works Cited
Ardalan, Abol. Economic & Financial Analysis for Engineering & Project Management. Lancaster, Penn: Technomic Pub. Co, 2000. Print.
Corbacioǧlu, Umut, and Erwin A. Laan. An Npv and Ac Analysis of a Multi-Product System with Remanufacturing. Rotterdam: Erasmus Research Institute of Management, Erasmus University, 2005. Print.
Gollier, Christian. Expected Net Present Value, Expected Net Future Value, and the Ramsey Rule. München: Univ., Center for Economic Studies, 2009. Print.
