Question

​Hassle-Free Web is bidding to provide web hosting services for Hotel Lisbon. Hotel Lisbon pays its current provider $ 10 comma 100 per year for hosting its web​ page, handling​ transactions, etc.​ Hassle-Free figures that it will need to purchase equipment worth $ 14 comma 900 up front and then spend $ 1 comma 900 per year on​ monitoring, updates, and bandwidth to provide the service for 3 years. If​ Hassle-Free's cost of capital is 10.1 %​, can it bid less than $ 10 comma 100 per year to provide the service and still increase its value by doing​ so?

Answer 1

Answer:

Yes, it can lower its price by more than $2,000 and still earn a larger than required profit.

Explanation:

current annual fee = $10,100

investment = -$14,900

cash flows 1-3 = $10,100 - $1,900 = $8,200

discount rate 10.1%

NPV = -$14,900 + $8,200/1.101 + $8,200/1.101² + $8,200/1.101³ = -$14,900 + $7,447.77 + $6,764.55 + $6,144 = $5,456.32

IRR = 30%

since the NPV is positive and the IRR is 30%, it means that the company will make a higher than expected profit from this transaction if it closes the sale at $10,100 per year. So, it has some margin to lower their bid to around $7,902 per year and still make enough profit to cover their required rate of return. At this price, the IRR = 10.1%.