Question

Executives at Microsoft are interested to get into the drone delivery business. Since it would take them too much time to set up their own operation, they decide to acquire “Flyit” corporation. “Flyit” has been operating a drone delivery service for 4 years now, and they are the most successful operators in the market. Microsoft executives offer “Flyit” two purchase options. The first option is one $40 million lump sum payment. The second option is paying five annual payments of $10 million over the next five years.

i) If the annual interest rate is 7%, find the present value of both options? [Note: you are supposed to show every step of your calculation and interpret the result]

ii)Evaluate the net present values of both option and identify which option is more cost effective for Microsoft?

Answer 1

Sub question (i)

Option 1: Lump sum Payment

In the absence of indication otherwise, it is assumed that the single lump sum payment of $40 Million is made in year 0. Hence the present value is the same, at $40 Million.

Option 2: Five Annual Payments

In this option, $10 Million is paid annually, over the next 5 years. It is assumed that the payments take place at the end of each year.

Present value of these payments is calculated as the present value of an annuity with discount rate at 7% annual and discounting frequency once in a year.

Screen shot of the step by step calculation in spread sheet is appended below.

It can be seen that in this option, even though total payment over 5 years is $50 Million, present value of the same is less at $41 Million, due to the operation of time value of money. Since the payments are deferred, each of such payments are worth less today, than the actual payment on the due date. Present value of each payment is P/(1+r)^n_i where n_i is the year number of year. Other variables as stated above. Present value of each payment is as follows:

End of Year	1	2	3	4	5	Total
Actual payment ($ Million)	10	10	10	10	10	50
Present value formula	10/(1+0.07)^1	10/(1+0.07)^2	10/(1+0.07)^3	10/(1+0.07)^4	10/(1+0.07)^5
Present value	9.3457943	8.73438728	8.16297877	7.62895212	7.12986179	41.001974

Sub question (ii):

It is observed that the present value of $40 Million in option (i) is less than the PV of $41 Million in option (ii) and hence option (i) is more cost-effective for Microsoft.