Suppose you have been hired as an independent contractor for

Suppose you have been hired as an independent contractor for a company to help with implantation 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 one year and half at the end of the second year. 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. Suppose the total value of the contract is $60,000 and the market interest rates is 2%. Calculate the present value of each option and determine which option you would choose. Explain why.

Solution

Present value, Option 1 ($) = 60,000 x (1/2) x P/F(2%, 1) + 60,000 x (1/2) x P/F(2%, 2)

= 30,000 x 0.9804 + 30,000 x 0.9612 = 29,412 + 28,836

= 58,248

Present value, Option 2 ($) = 60,000 x 25% + 60,000 x 50% x P/F(2%, 1) + 60,000 x 25% x P/F(2%, 2)

= 15,000 + 30,000 x 0.9804 + 15,000 x 0.9612 = 15,000 + 29,412 + 14,418

= 58,830

Since option 2 has higher present value, I will choose option 2.