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

Background:

BTC is evaluating selling a part of its telecommunication system to one of its business customers.

While the initial purchase consideration is barely enough to cover the direct costs, there are expected future cash inflows due to which the NPV and IRR seems attractive.

Response:

In Support

In this instance, if one looks at Day 0 cash inflow, it is not enough to meet the desired rate of return. Over the longer horizon, both the variable and the fixed costs must be met. In this case only the variable costs (direct costs) are being met from sale of business. Hence, it looks unattractive from that perspective.

However, when evaluating it as a project, all the future cash inflows must also be considered. As significant follow-on business is expected, the future postive cash flows lead to a positive NPV and IRR higher that the cost of capital.

A capital budgeting project is to be analysed using the NPV and the IRR methods. This project is yielding a postive NPV and the IRR above its cost of capital and hence the project is acceptable.

Hence, BTC's decision to sell this business in light of future business can be supported.

In Criticism:

The cash flows from follow on business is uncertain, as there is no mention of any guaranteed revenue commitment on sale of business. If the follow on revenue does not pan out as expected, or if the cost of delivery increases more than anticipated, it may turn out to be a less favourable project. The actual NPV and IRR may turn out lower than exected.

If a large part of business is carried in this manner, it may lead to going concern challenges for BTC during an economic downturn.

Hence, it is advisable to incorporate revenue guarantee as part of the business sale, such that future cash inflows are reasonably certain.

Conclusion:

As BTC has already decided to sell the business, BTC should also consider entering into a side-agreement to get the business customer to provide a revenue commitment for a few years. This will provide greater visibility on this deal's eventual outcome.