Suppose you have been hired as an independent contractor for a company to help w

Question

Suppose you have been hired as an independent contractor for a company to help with implementation of a new software system. You have been asked to layout the timeline for the deliverables of the project and the costs. In the timeline, the company would like to pay you half of the contract value at the end of year one and half at the end of year two. The other option is to pay you 25% of the contract value at the beginning, 50% at the end of the first year and the remaining 25% at the end of the second year. If the total value of the contract is $40000 and the market interest rates is 4%, which option would you choose? Explain why.

Explanation / Answer

Option - 1

50% of contract value to be paid at end of year 1 & 50% at end of year 2.

Contract value = $40,000

So,

Payment received at end of year 1 = $20,000

Payment received at end of year 2 = $20,000

Present value of these payments = $20,000 / (1.04) + $20,000 / (1.04)2

= $19,231 + $18,491

= $37,722

Option - 2

Payment at beginning = 25% x $40,000 = $10,000

Payment at end of year 1 = 50% x $40,000 = $20,000

Payment at end of year 2 = 25% x $40,000 = $10,000

Present value = $10,000 + $20,000 / 1.04 + $10,000 / (1.04)2

= $(10,000 + 19,231 + 9,246)

= $38,477

Since option 2 provides a higher present value than option 1, option 2 will be chosen.

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