Executives at Microsoft are interested to get into the drone delivery business. Since it would take them too much time to set up their own operation, they decide to acquire “Flyit” corporation. “Flyit” has been operating a drone delivery service for 4 years now, and they are the most successful operators in the market. Microsoft executives offer “Flyit” two purchase options. The first option is one $40 million lump sum payment. The second option is paying five annual payments of $10 million over the next five years.a) If the annual interest rate is 7%, find the present value of both options? [Note: you are supposed to show every step of your calculation and interpret the result] b) Evaluate the net present values of both option and identify which option is more cost effective for Microsoft?

Question
Asked Oct 15, 2019
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Executives at Microsoft are interested to get into the drone delivery business. Since it would take them too much time to set up their own operation, they decide to acquire “Flyit” corporation. “Flyit” has been operating a drone delivery service for 4 years now, and they are the most successful operators in the market. Microsoft executives offer “Flyit” two purchase options. The first option is one $40 million lump sum payment. The second option is paying five annual payments of $10 million over the next five years.
a) If the annual interest rate is 7%, find the present value of both options? [Note: you are supposed to show every step of your calculation and interpret the result] 
b) Evaluate the net present values of both option and identify which option is more cost effective for Microsoft? 

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Expert Answer

Step 1

(a) Calculation of present values of two options:

Answer:

Net present values of both options are $40 million and $41 million.

Option 1: Lump sum payment

Note: Nothing is mentioned, it is assumed that single lump sum payment of $40 million is made in 0 year. Therefore, the present value is $40 million.

Step 2

Option 2: Based on five annual payments

Calculation of present value:

Excel workings:

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Particulars Periodical payments (P) Rate of interest (r) Compounded per year (t) Number of years (Y) Number of periods (n) Amount in Million $ 10 0.07 1 55 5 Present value $41.00

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Step 3

Excel spreadsheet:

...
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A B Particulars Amount in Million $ 1 10 0.07 1 5 =B4*B5 2 Periodical payments (P) 3 Rate of interest (1) 4 Compounded per year (t) 5 Number of years (Y 6 Number of periods (n) |=PV(B3,B6,B2,0,0) 8 Present value

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