Question

Hassle-Free Web is bidding to provide web hosting services for Hotel Lisbon. Hotel Lisbon pays its current provider $10,400 per year for hosting its web page, handling transactions, etc. Hassle-Free figures that it will need to purchase equipment worth $15,000 up front and then spend $2,000 per year on monitoring, updates, and bandwidth to provide the service for 3 years. If Hassle-Free's cost of capital is 9.9%, can it bid less than $10,400 per year to provide the service and still increase its value by doing so? Hassle-Free can bid as low as $ . (Round to the nearest dollar.)

Answer 1

Value is increased if the NPV is positive

NPV = sum of present value of cash flows

present value of each cash flow = cash flow / (1 + cost of capital)n

where n = number of years after which the cash flow occurs

First, we assume the bid to be $10,400 and calculate the NPV.

NPV is $4,930

D C $10,000 1 Bid price Cost of Net Cash PV of cash 2 Year equipment Expenses Revenue Flow flow 0 $ 15,000 $(15,000) $ (15,000) $ 2,000 $10,000 $ 8,000 $ 7,279 $ 2,000 $10,000 $8,000 $ 6,624 $ 2,000 $10,000 $ 8,000 $ 6,027 NPV $ 4,930 wN

A 1 Bid pric 10000 Revenue 2 Year 30 Cost of equipment Expenses 15000 2000 2000 2000 Net Cash Flow =-B3 =D4-C4 =D5-C5 =D6-C6 NPV =$C$1 =$C$1 =$C$1 PV of cash flow =E3/(1+9.9%)^A3 =E4/(1+9.9%)^A4 =E5/(1+9.9%)^A5 =E6/(1+9.9%) A6 =SUM(F3:F6) Nm

Next, we calculate the lowest bid price which will result in a positive NPV (an NPV of at least $1)

The lowest bid price is calculated using Goal Seek in Excel :

I ДА C D E F G H 1 Bid price $10,000 Goal Seek Cost of Net Cash PV of cash 2 Year equipment Expenses Revenue Flow flow Set cell: SF57 0 $ 15,000 $(15,000) $ (15,000) To value: $ 2,000 $10,000 $ 8,000 $ 7,279 By changing cell: SCS1 $ 2,000 $10,000 $ 8,000 $ 6,624 $ 2,000 $10,000 $ 8,000 $ 6,027 OK NPV $ 4,930 1 Cancel

The lowest bid price which will create value is $8,022

B D E F A 1 Bid price C $8,022 2 Year Cost of Net Cash PV of equipment Expenses Revenue Flow cash flow 0 $ 15,000 $(15,000) $(15,000) $ 2,000 $ 8,022 $ 6,022 $ 5,479 $ 2,000 $ 8,022 $ 6,022 $ 4,986 $ 2,000 $ 8,022 $ 6,022 $ 4,536 NPV $ 1