Rayfurd is considering two options for comparable computer software. Option A wi

Question

Rayfurd is considering two options for comparable computer software. Option A will cost $25,000 plus annual license renewals of $1,000 for three years, which includes technical support. Option B will cost $20,000 with technical support being an add-on charge. The estimated cost of technical support is $4,000 the first year, $3,000 the second year, and $2,000 the third year. Assume the software is purchased and paid for at the beginning of year one, but that technical support is paid for at the end of each year. Interest is at 8%. Ignore income taxes.

Explanation / Answer

Option A:

Cash Outflow at the beginning of year of Software Purchased

                                                                   = $25,000

It is given that amount for technical support is paid at the end of each year. The annual license renewals of $1000 for three years includes technical support. Hence, calculating the Present Value of the amount of cash outflows:

Cash Outflow($)       Discounting Factor(8%)        Present Value ($)

1000                                  0.926                                  926

1000                                  0.857                                  857

1000                                  0.794                                 794

                       Total Present Value of Outflow ($)      2577  

Therefore, total Outflow at the beginning of year 1 = $ ( 25000+2577)
                                                                                 = $ 27,577

Option B:

Cash Outflow at the beginning of year of Software Purchased

                                                                   = $20,000

It is given that amount for technical support is paid at the end of each year. Hence, calculating the Present Value of the cash outflows:

Cash Outflow($)       Discounting Factor(8%)        Present Value ($)

4000                                  0.926                                  3704

3000                                  0.857                                  2571

2000                                  0.794                                 1588

                       Total Present Value of Outflow ($)       7863

Therefore, total Outflow at the beginning of year 1 = $ ( 20,000+ 7863)
                                                                                 = $ 27,863

Since the Outflow in Option B is greater that ouflow in Option A by $286, it is advisable that Rayfurd should opt for Option A.

Note : Calculation of the Discounting Factor is done as follows :

Interest Rate as per the Question = 8%

Discounting Factor for Year 1 :

Step 1: 8/100 = 0.08

Step 2 : 1+0.08 = 1.08

Step 3: 1/1.08

             = 0.926

The Discounting Factors for year 2   :

Step 1: 8/100 = 0.08

Step 2 : 1+0.08 = 1.08

Step 3: 1/(1.08)(1.08)

             = 0.857

The Discounting Factors for year 3   :

Step 1: 8/100 = 0.08

Step 2 : 1+0.08 = 1.08

Step 3: 1/(1.08)(1.08)(1.08)

             = 0.794

  

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