Question

Bowman Corporation is considering an investment in special-purpose equipment to enable the company to obtain a...

Bowman Corporation is considering an investment in special-purpose equipment to enable the company to obtain a five-year 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 (straight-line 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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