Question
Sonic, Inc., sells business software. Currently, all of its programs come on disks. Due to their complexity, some of these applications occupy as many as
Sonic, Inc., sells business software. Currently, all of its programs come on disks. Due to their complexity, some of these applications occupy as many as seven disks. Not only are the disks cumbersome for customers to load, but they are relatively expensive for Sonic to purchase. The company does not intend to discontinue using disks altogether. However, it does want to reduce its reliance on the disk medium.
Two proposals are being considered. The first is to provide software on computer chips. Doing so requires a $300,000 investment in equipment. The second is to make software available through a computerized software bank. In essence, programs would be downloaded directly from Sonic using telecommunications technology. Customers would gain access to Sonics mainframe; specify the program they wish to order; and provide their name, address, and credit card information. The software would then be transferred directly to the customers hard drive, and copies of the users manual and registration material would be mailed the same day. This proposal requires an initial investment of $240,000.
The following information pertains to the two proposals. Due to rapidly changing technology, neither proposal is expected to have any salvage value or an estimated life exceeding six years.
Computer Chip Equipment | Software Bank Installation | |
Estimated incremental annual revenue of investment | 300,000 | 160,000 |
Estimated incremental annual expense of investment (including taxes and depreciation) | 250,000 | 130,000 |
The only difference between Sonics incremental cash flows and its incremental income is attributable to depreciation. A minimum return on investment of 15 percent is required.
a. Compute the payback period of each proposal.
b. Compute the return on average investment of each proposal.
c. Compute the net present value of each proposal using the tables in Exhibits 263 and 264.
d. What nonfinancial factors should be considered?
Computer Chip | Software Bank | |||
Investement | 300,000 | Investement | 240,000 | |
Service life, years | 6 | Service life, years | 6 | |
Salvage Value at end of life | - | Salvage Value at end of life | - | |
Est. Incremental annual revenue | 300,000 | Est. Incremental annual revenue | 160,000 | |
Est. incremental annual expense (including tax & depr) | 250,000 | Est. incremental annual expense (including tax & depr) | 130,000 | |
RRR | 15% | RRR | 15% | |
Depreciation | 50,000 | Depreciation | 40,000 | |
Computer Chip | Software Bank | |||
The supporting calculations for the payback figure are: | The supporting calculations for the payback figure are: | |||
Incremental annual revenue of investment | 300,000 | Incremental annual revenue of investment | 160,000 | |
Less: Incremental annual expenses of investment | (250,000) | Less: Incremental annual expenses of investment | (130,000) | |
Incremental annual income of investment | 50,000 | Incremental annual income of investment | 30,000 | |
Add: Depreciation expense | 50,000 | Add: Depreciation expense | 40,000 | |
Incremental annual cash flow of investment | 100,000 | Incremental annual cash flow of investment | 70,000 | |
Payback | 3.00 | years | Payback | 3.43 |
Computer Chip | Software Bank | |||
Average Net Income | 50,000 | Average Net Income | 30,000 | |
Average Investment | 150,000 | Average Investment | 120,000 | |
Return on Investment | 33.3% | Return on Investment | 25.0% | |
Computer Chip | Software Bank | |||
PV of Cash Flows | 378,400 | PV of Cash Flows | 264,880 | |
Cost of Investment | (300,000) | Cost of Investment | (240,000) | |
Net Present Value | 78,400 | Net Present Value | 24,880 | |
Factor @ 6yr, 15% | 3.784 |
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