company must decide whether to invest $$100$ million in developing and

implementing a new enterprise system in the face of considerable technological and market

$($demand for product and market share$)$ uncertainty. The firm's cost of capital is $10\%.$

$1.$ Evaluate Using Conventional NPV Analysis

There can be a good and bad result for this investment.

Good Result: A good result has a probability of $\mathrm{.}7$ of occurring. Here the planned cost

reductions have been realized and better integration of the supply chain is possible. These

benefits are reinforced by strong market demand for the firm's product. There have also been

feedback benefits, the enterprise systems has significantly improved perceived quality and

service from the customer's point of view. Annual benefits under this scenario equal $$15$ million

in after tax cash flow per year.

Bad Result: The system proves to be more difficult to implement and improvements in

management of the supply chain are less. In addition, the growth in market demand for the

product is lower. Annual benefits under this scenario are $$2$ million in after tax cash flow per

year.

Using traditional "all or nothing" NPV analysis, calculate the expected NPV of the project:

Given: Year $0($now$)$ cash flows: $$-100$ million for ERP purchase and implementation

See the attached NPV Diagram in this module.

$2.$ Real Options Approach $($all cash flows are after tax$)$

Now, evaluate the investment using managerial flexibility and a real options approach.

The real options alternative allows for flexibility and the delay of the investment for $1$ year. In this

case, if we do a pilot project we will be better able to evaluate ERP implementation

complexities, achievable supply chain benefits, and the market share our products will achieve.

However, the cost of the project will rise to $$110$ Million $($$$10$ Million this year and $$100$ Million

next year$)$ with the one$-$year delay and additionally management decides to purchase and

implement the financial module in year $1$ at a cost of $$10$ Million $($real option$).$

The results are slightly different:

Year $0($now$)$ cash flows: $$10$ million for the pilot project, the financial module