Fifth Third Bank is considering the acquisition of a new data processing and management information system. The system, including computer hardware and software, will cost $15 million.

To put this new system in place, the bank expects to have to make an investment of $1,000,000 in net working capital immediately and an additional net working capital investment of $500,000/year for the next 4 years. The total NWC investment will be recouped whenever the project ends.

The system has an expected economic life of 10 years. It will be straight-line depreciated to zero over the expected economic life. Actual salvage value at the end of 10 years is expected to be $1,000,000, and the bank plans to sell the system for its salvage value at that time.

The new data processing system will save the bank the $3,500,000 fee per year that it currently pays to a computer time-sharing company. Operating, maintenance, and insurance costs for the system are estimated to total $750,000 during the first year. These costs are expected to increase at a rate of 6 percent per year over the 10-year period. Fifth Third annual interest expense equals the initial cost of the equipment times the interest rate of 6.6%.

Fifth Third plans to sell excess computer time to a number of local firms. Based on an analysis of the local market for computer time, the bank feels that it can charge $20 per unit of computer time and would be able to sell 260,000 units of computer time at that price. Although the bank does not anticipate changing this charge over the 10-year period, it expects the quantity demanded to decline by 4 percent per year after year 1. It is expected that these outside sales of computer time will cost the bank an additional $650,000 per year in computer operating costs (including the salaries of computer services representatives to handle the new customers). These additional operating costs are expected to increase at a rate of 5 percent annually over the 10-year period.

The bank has an effective average tax rate of 32 percent. This rate is expected to remain in effect over the life of the project. Fifth Third requires a 12% rate of return on projects of this risk.

1. Should Fifth Third undertake this project? Explain/show.

2. Suppose they believe their annual cost savings estimates may be off by +/- 8 percent; operating, maintenance and insurance as well as outside sales costs may vary +/- 4%; their quantity estimates for secondary demand may differ +/- 5%; and the price of the secondary demand may fluctuate +/- 20%

a. Calculate the best case scenario value of this project.

b. Calculate the worst case scenario value of this project.

c. Based on the baseline (original projections), how sensitive is the NPV of this project to changes in what they can charge for computer time to other local firms?

3.

a. What is the NPV of the project, if, instead of following the original assumed path, the secondary demand declines 20% per year after year 1 and then disappears after year 5?

b. If there is a 50% chance that this second outcome (hugely reduced demand) will happen and a 50% chance the original secondary demand projection will be correct, what is the expected NPV of the project?

c. Suppose Fifth Third believes, if secondary demand collapses as in the second scenario, they would have the option to abandon this project after 4 years and sell off the equipment. They believe they could sell the equipment at that time for $10.5 million. What is the NPV of the project taking this real option into account?