Bowman Corporation is considering an investment in specialpurpose equipment to enable the company to obtain a fiveyear government contract for the manufacture of a special item. The equipment costs $500,000 and would have no salvage value when the contract expires at the end of the five years. Estimated annual operating results of the project are as follows.
Revenue from contract sales  $  700,000  
Expenses other than depreciation  $  400,000  
Depreciation (straightline basis)  100,000  500,000  
Increase in net income from contract work  $  200,000  
All revenue and all expenses other than depreciation will be received or paid in cash in the same period as recognized for accounting purposes. Compute the following for Bowman’s proposal to undertake the contract work.
a. Payback period. (Round pay back period year to 2 decimal places.)
b. Return on average investment.
c. Net present value of the proposal to undertake contract work, discounted at an annual rate of 10 percent. (Refer to the annuity table in Exhibit 26–4.) (Round your "PV factors" to 3 decimal places.)
Solution:
Part a – Payback Period
Payback period is the length of time within which the proposed initial investment in project is expected to be recovered. This technique of capital budgeting considers Cash Flows for calculation.
Annual Cash Inflows = Revenue – Expenses excluding depreciation
= 700,000 – 400,000
= 300,000
Initial Investment = $500,000
Payback Period = Initial Investment / Annual Cash Inflows = $500,000 / 300,000 = 1.67 years
Part b – Return on Average Investment
This is a technique of capital budgeting for evaluation of project. This method considers net income after depreciation to calculate the return on avg investment.
Average Investment = (Initial Investment + Salvage Value) / 2 = (500,000 + 0) / 2 = $225,000
Return on Average Investment = Net Income after depreciation / Average Investment x 100
= $200,000 / $225,000 x 100
= 88.89%
Part c – Net Present Value
Year 
0 
1 
2 
3 
4 
5 
Initial Investment (Cash Outflow) 
($500,000) 

Annual Cash Inflows 
$300,000 
$300,000 
$300,000 
$300,000 
$300,000 

Net Cash Flows 
($500,000) 
$300,000 
$300,000 
$300,000 
$300,000 
$300,000 
Discount Factor @ 10% 
1 
0.909 
0.826 
0.751 
0.683 
0.621 
Present Value of Cash Flows 
($500,000) 
$272,700 
$247,800 
$225,300 
$204,900 
$186,300 
Net Present Value 
$637,000 
The proposal to undertake contract work should be selected since the NPV is positive.
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