Question

Assume that Sonic Foundry Corporation has a contractual debt outstanding. Sonic has available two means of settlement. It can either make immediate payment of $2,600,000, or it can make annual payments of $300,000 for 15 years, each payment due on the last day of the year.

Which method of payment do you recommend, assuming an expected effective interest rate of 8% during the future period?

Answer 1

Present value - Immediate payment = $2,600,000

Present value - installments = 2,567,843.61

Based on the comparison of present value for both options, Sonic Foundry Corporation should choose option 2 which is annual payments of $300000 for 15 years as it has a lower present value as compared to immediate payment.

Step-by-step explanation:

We will first need to calculate the present value of the option with payments in installments for 15 years. To calculate the present value, we will use the formula for present value of annuity ordinary as the payments qualify as ordinary annuity.

The payments qualify as ordinary annuity as the payments are of equal amount, are made after equal intervals of time and are for a limited time period and made at the end of the period. The formula for present value of ordinary annuity is attached.

Present value - Option 2 = 300000 * [(1 - (1+0.08)^-15) / 0.08]

Present value - Option 2 = $2,567,843.606 rounded off to $2,567,843.61

The present value of option 1 which is immediate payment is equal to the payment amount as it is made today and it is $2,600,000.

Based on the comparison of present value for both options, Sonic Foundry Corporation should choose option 2 which is annual payments of $300000 for 15 years as it has a lower present value as compared to immediate payment.