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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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