Business Finance help?
Mr. Rambo, President of Assault Weapons, Inc., was pleased to hear that he had three offers from major defense companies for his latest missile firing automatic ejector. He will use a discount rate of 12 percent to evaluate each offer.
Offer 1
$500,000 now plus $120,000 from the end of year 6 through 15. Also, if the product goes over $50 million in cumulative sales by the end of year 15, he will receive an additional $1,500,000. Rambo thought there was a 75% probability this would happen.
Offer 2
25% of the buyer’s gross margin for the next four years. The buyer in this case is Air Defense, Inc. (ADI). Its gross margin is 65%. Sales for year 1 are projected to be $1 million and then grow by 40% per year. This amount is paid today and is not discounted.
Offer 3
A trust fund would be set up for the next 9 years. At the end of that period, Rambo would receive the proceeds (and discount them back to the present at 12%). The trust fund called for semiannual payments for the next 9 years of $80,000 (a total of $160,000 per year). The payments would start immediately. Since the payments are coming at the beginning of each period instead of the end, this is an annuity due. To look up the future value of the annuity due in the tables, add 1 to n (18 + 1) and subtract 1 from the value in the table. Assume the annual interest rate on this annuity is 12% annually. Determine the present value of the trust fund’s final value.
Required:
Show work and find the present value of each of the three offers and then indicate which one has the highest present value.
For each payment that would be received in each offer, you need to discount it to the present value. Then you add all the present values of each payment for each offer. To discount each payment to the present value, you divide it by ((1+i)^n.)
i is the interest rate, which in your question would be 12%.
n is the number (which would be years if the interest rate is presented as an annual rate.)
^ means exponent
* means multiply
For example, in offer 1 the present value of the $500,000 that would be received now is the full $500,000. Then the first $120,000 payment gets received in 6 years, so 120,000/(1.12^6) = $60,795.73 which is the present value. That number can be seen as the amount that would have to be invested today to grow to $120,000 in 6 years at a 12% annual rate.
So for each payment that would be received in offer 1, you discount them to the present value and add the present value of each payment. Then you do the same for offers 2 and 3 and find which one is the largest amount.
You also need to consider things like the 75% probability in offer 1. To account for that, you multiply the amount that would be received by the probability rate (1,500,000*.75) to get a net amount. Then you discount that to the present value to include it with the other payments.