Question

Consider the following investment offers regarding a product you have recently developed. A 10% interest rate should be used throughout this analysis unless otherwise specified:

Offer (I) – Receive $0.51m now and $197k from year 6 through 15. Also, if your product achieved over $100 million in cumulative sales by the end of year 15, you would receive an additional $3m. Assume that there is a 70% probability this would happen.

Offer (II) – Receive 30% of the buyer’s gross profit on the product for the next 4 years. Assume that the buyer’s gross profit margin is 60%. Sales in year 1 are projected to be $1.9m and then expected to grow by 40% per year.

Offer (III) – A trust fund would be set up, calling for semiannual payments of $207k for 8 years. On the 17th period, you would receive the compounded proceeds, which would then be discounted over the 8-year period back to the present at the specified annual rate.

Note: The term “k” is used to represent thousands (× $1,000).

Required: Determine the percentage difference between your most and least profitable alternatives, with the least profitable option as the basis for your calculation.

Answer% Intermediate calculations must be rounded to 3 decimal places (at least). Input your answer as a percent rounded to 2 decimal places (for example: 28.31%).

Answer 1

Refer detailed working screen shot with below key points which will be helpful in understanding the table:

Discount rate is 10%.

1. To arrive at PV Factor 1 is divided by discount rate that is 1/ (1+10%) or 1.1.   

2. PV for the year is nothing but multiplication of amount under different options and PV factor computed as per step 1 above.

3. In Option 1, receipt of $3m is subject to 100m Cumulative sales in 15 year and has 70% probability of achieving. So calculation is $3m*70%*15th year PV Factor i.e.. 0.24 = $0.5m

4. In option 2, first year sales is $1.9m and growing 40% PA having a profit margin of 60% on sales and commission on margin is 30%. Commission is computed as "Sales*Margin*commission.

5. In option 3, $207k on semi-annual basis for 8 years received on 17th period. i.e.. 207*2*8 = $3.312m multiplied by PV factor or 8th year 0.47 = $1.55 which is total income under this option.

Analysis :-

Options 3 is least profitable option and therefore should be avoided.

Option 2 profit is 19.35% higher than option 3 which is ($1.85/$1.55-1)

Option1 Profit is $1.76m including additional commission which is 13.54% higher than Option 3 (1.76/1.55-1)

Recommendation

Option 2 is highly profitable option amongst all. Therefore should be adopted.