Question

BTS has decided that they wish to bid and sell a large telephone communications system to a major business customer. What is similar about the industry and the business is that the vendor selling a system gets substantial follow-on business in later years by making changes and alterations to that system. The marketing department wants to take an incremental approach to the bid, basically treating it as a capital budgeting project. They propose selling the system at or below its direct cost in labor and materials (the incremental cost) to ensure getting the follow-on business. BTC has projected the value of that business by treating future sales less direct costs as cash inflows. They maintain that the initial outlay is the direct cost to install the system, which is almost immediately paid back by the price. Future cash flows are then the net inflows from the follow-on sales. These calculations have led to an enormous NPV and IRR for the sale viewed as a project. Both support and criticize this approach. (Hint: what would happen if BTC did most of its business this way?)

Answer 1

Support of this approach : In this business model company is relying on follow up business. Here the company will recover almost most of its cost in initial year of operations. But for revenue it has to wait for follow on business in later years. This approach is good as company can ensure future earnings from same projects for longer durations. Impact of this approach would be that company would have Nil or negative cash flow in initial year but positive cash flows subsequently. But when cash flows are certain, shareholders will be secured about the company future and they will invest in this company. As stated above calculations shows that company is having enormous NPV and IRR. So, this approach is promising for BTC.  

Criticism of this approach : This approach is not good if all the business of BTC is running the same way. As it has to rely on follow on business in coming years for its whole and sole revenue model. Besides if there are multiple projects in coming years then capital expenditure will be so high that it would be difficult for business to show growth in initial years. It will be difficult for investors also to invest in such company whose future is not certain for coming years. Besides BTC would have to take huge debt financing to finance this projects, the impact of which would be that profits in coming years would be offset by interest payments. Secondly, if projects on which they are depending could not run sucessfully then also BTC will be left with nothing. So, it is a risky business model.