Sonic, Inc., sells business software. Currently, all of its programs come on dis

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.

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.

f. Which proposal, if either, do you recommend Sonic choose?

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

Explanation / Answer

Sonic should choose computer chip equipment for the following reason 1. Payback period-Investment with less payback period is prefered. Since it means we get back our investment amount in less time. So Computer chip equipment has less payback period. 2. Average Return-The investment with more return is prefered. Computer chip equipment has higher return rate than software bank installation 3. Net Present Value- Higher NPV is prefered. Computer chip has higher Net present value.

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