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company must decide whether to invest $ 1 0 0 million in developing and implementing a new enterprise system in the face of considerable technological
company must decide whether to invest $ 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
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 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 $ 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 $ million in after tax cash flow per
year.
Using traditional "all or nothing" NPV analysis, calculate the expected NPV of the project:
Given: Year now cash flows: $ million for ERP purchase and implementation
See the attached NPV Diagram in this module.
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 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 $ Million $ Million this year and $ Million
next year with the oneyear delay and additionally management decides to purchase and
implement the financial module in year at a cost of $ Million real option
The results are slightly different:
Year now cash flows: $ million for the pilot project, the financial module
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