Simes Innovations, Inc., is negotiating to purchase exclusive rights to manufact

Question

Simes Innovations, Inc., is negotiating to purchase exclusive rights to manufacture and market a solar-powered toy car. The car's inventor has offered Simes the choice of either a one-time payment of $2,400,000 today or a series of 9 year-end payments of $375,000.
a. If Simes has a cost of capital of 9%, which form of payment should it choose?
b. What yearly payment would make the two offers identical in value at a cost of capital of 9%?
c. What would be your answer to part a of this problem if the yearly payments were made at the beginning of each year?
d. The after-tax cash inflows associated with this purchase are projected to amount to $243,750 per year for 16 years. Will this factor change the firm's decision about how to fund the initital investment?

Explanation / Answer

Answer a Present value of annuity = C * [ {1 - (1+i)^-n} / i] C = Cash flow per period = $375000 I = cost of capital = 9% n = no.of payments = 9 Present value of annuity = $375000 * [ {1 - (1+0.09)^-9} / 0.09] = $375000 * 5.995247 = $2248218 Simes should choose 9 year end payments of $375000 as it has present value equal to $2248218 which is lower than the one time payment of $24,00,000. Answer b Present value of annuity = C * [ {1 - (1+i)^-n} / i] Present value of annuity = $24,00,000 C = Cash flow per period = ? I = cost of capital = 9% n = no.of payments = 9 2400000 = C * [ {1 - (1+0.09)^-9} / 0.09] C = 2400000 / 5.995247 = $400317 $400317 yearly payment would make the two offers identical in value at a cost of capital of 9% Answer C Present value of annuity = (C * 1) + C * [ {1 - (1+i)^-n} / i] C = Cash flow per period = $375000 I = cost of capital = 9% n = no.of payments = 8 Present value of annuity = ($375000*1) + $375000 * [ {1 - (1+0.09)^-8} / 0.09] = $375000 + ($375000 * 5.534819) = $2450557 Simes should choose one time payment of $2400000 as the present value of installment payments is equal to $2450557 which is more than the one time payment. Answer d The future After tax cash inflow factor will not change firm's decision about how to fund the initial investment as inflow will remain sasme under both option.

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