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 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 Sonic’s 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 customer’s hard drive, and copies of the user’s 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 Sonic’s 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 26–3 and 26–4.

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

Answer 1

Since, first 3 parts have already been answered, I have not answered the same.

However, I would like to point out that, in the second case, Depreciation should be taken as $ 30000 instead of $ 40000 i.e. ($ 160,000 - $ 130,000).

Sonic Inc, should consider the following non-financial factors-

1 ) As the disks are outdated and there is technological upgradation, they need to upgarde there technological standards to compete with other players of the market.

2 ) It should have the requisite experienced personnels for efficient & effective operations.

3 ) It should also consider the relevant government laws and regulations before implementing the project.

4 ) The customers are the most important asset of an organisation, so it should look upto the customer satisfaction too.

5 ) While using the telecommunication facilty, it should have good internal controls, so that the data can is not leaked in the transit phase and does not have any unauthorised access.