Question

You have received the following three payment options for a software application you have developed to sell:

Option 1

You will receive $1,000,000 now plus $200,000 from year 6 through 15. Also, if the software application did over $100 million in cumulative sales by the end of year 15, you will receive an additional $3,000,000. There is a 70 percent probability this would happen.

Option 2

You will receive thirty percent of the buyer’s gross profit on the product for the next four years. The buyer’s gross profit margin is 60 percent. Sales in year one were projected to be $2 million and then expected to grow by 40 percent per year.

Option 3

A trust fund would be set up for the next eight years. At the end of that period, you will receive the proceeds (and discount them back to the present at 10 percent). The trust fund called for semiannual payments for the next eight years of $200,000 (a total of $400,000 per year).

The payments would start immediately. The annual interest rate on this annuity is 10 percent annually (5 percent semiannually). Hint: Since the payments are coming at the beginning of each period instead of the end, this is an annuity due.

NOTE: Use a 10 percent interest rate throughout this analysis, unless otherwise specified.

Your task:

A. Determine the present value of each of the payment options. You must show the details

of your work to receive credit (3 points for each option)

B. Create a bar graph in Excel that clearly shows the three options’ present values. Your

graph must be polished and professional with proper title and format. The graph should

be less than a half-page in size. (3 points)

C. Explain the best payment option in one sentence (3 points)

Answer 1

We will analyse all the 3 payment options and their respective present value worksheets are as below:

Note the following for the calculations above:

• Under option 1, there is a possible pay out of $3 million after 15 years if the cumulative sales are above $100 million. Since the probability of this event is 70%, we have taken the expected pay out at (3000000 * 70%) = 2100000
• Under option 3, we have used the formula for future value of annuity due : ; where r is semi annual interest rate at 5%, t is the number of semi annual periods at 32, and Periodic Payment is $200,000 per semi annual period. Plugging in the values, we get the Future value after 8 years to be $ 4968073

The bar graph is as below:

As we can see the present value for the Option 3 is the highest and also as an aside under option 3, there is no conditionality like in option 1 a large payout is backended with 70% probability and in option 2 the pay out is a function of sales & gross margin.