Question

Percy has been given the options of two computer software programs: “Aay” or “Bee”.

Aay costs $50,000 with a useful life of 5 years and Bee costs $37,000 with a useful life of

4 years. Cash inflows from Aay are expected to be $44,000pa whilst Bee is expecting

$37,000pa. Meanwhile, it has been known from past experience that new computer programs require things such as training new staff and additional PC protection kits. As Aay is more advanced than Bee, it is estimated to take a longer time to train the staff and hence it is estimated to cost $25,000pa compared to the $9000pa if Percy used Bee.

At the end of their useful life, Aay is estimated to be worth $3,300 whilst Bee only

$1,980, with the chosen one being replaced on a recurring basis. Percy will be using straight line depreciation for accounting and tax purposes (no matter what their salvage is). If both programs have an RRR of 17% after tax and Percy pays income tax of 40%, which is the most beneficial to him?

Calculate using the NPV in perpetuity method.

Answer 1

Given

Machine	Aay	Bee
Costs	50000	37000
	5	4
Annual Return	44000	37000
Annual Costs	25000	9000
Annual Net Cash Inflows	19000	28000
Residual Value	3300	1980

For Choosing option we have to calculate Equated annual benifit

EAB = NPV / Present Value Annuity Factor

  

Aay
Year	Costs	Present Value Factor/Annuity Factor	Net Cash flow
0	50000	1	50000
1 to 5	19000	3.1993	60786.7
5	3300	0.4561	1505.13
		Total NPV	112291.83

EAB = 112291.83 / 3.1993

= $ 35098.87

Bee
Year	Costs	Present Value Factor/Annuity Factor	Net Cash flow
0	37000	1	37000
1 to 4	28000	2.7432	76809.60
5	1980	0.5337	1056.73
		Total	114866.33

EAB = 114866.33 / 2.7432

= $ 41873

Formula for present value interest annuity factor =

or we can use PV function in Excel = PV (Interest Rate,years,payment)

r = Periodic rate per period

n = Number of periods

Formula for present value interest factor = 1 / (1+r)^n  

Equated annual benefit for "Bee" is greater than "Aay", therefore Bee is better Option.