1. (20 points) A Yellow Pages directory company must decide whether it should co

Question

1. (20 points) A Yellow Pages directory company must decide whether it should compose the ads for its clients inhouse or pay a production company to compose them. To develop the ads inhouse, the company will have to purchase computers, printers, and other peripherals at a cost of $15,000. The equipment will have a useful life of 5 years, after which it will be sold for $3000. The employee who creates the ads will be paid $40.000 per year. In addition, each ad will have an average cost of $9 to prepare for delivery to the printer. Alternatively, the company can outsource ad development at a fee of $22 per ad regardless of the quantity. The current interest rate is 8% per year. What is the breakeven amount of ads?

Explanation / Answer

The breakeven amount of ads is the ads at which present value of developing inhouse and the present value of hiring a production company would be equal. Let the no. of Ads by 'A'.

Developing Inhouse

Note - For years 1 - 5, I have taken Present value interest factor Annuity (PVIFA) and for single years it would be present value factor (PVF).

Hiring Production company

Present Value = Cost of outsourcing and developing x no. of ads x PVIFA (8%, 5 years)

Or, Present Value = $22 x A x 3.99271003698 = 87.8396208135 A

Now, we equate the two present values -

Present value of Developing Inhouse = Present value of hiring production company

Or, 35.9343903328 A +157666.651888 = 87.8396208135 A

Or, 51.9052304807 A = 157666.651888

Or, A = 157666.651888 / 51.9052304807 = 3037.58697202 or 3038 (rounded off)

So, the breakeven number of ads = 3038

Present Value Particulars Year PVF@8% Amount ($) Present Value ($) Cost of computers and peripherals 1 0 15000 15000 Add: Employee Salary 1 - 5 3.99271003698 40000 159708.401479 Add: Average Cost to prepare 1 - 5 3.99271003698 A x $9 = 9A 35.9343903328 A Less: Salvage Value 5 0.680583197 3000 2041.749591 Total Present Value 35.9343903328 A +157666.651888

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