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.

e. Which of Sonic’s employees would most likely underestimate the benefits of investing in the software bank? Why?

	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
a	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
b	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%
c	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