Question

Pacific Marine services has been offered a contract to provide highly classified services to the U.S. Navy. The contract is for 8 years. The projected costs and revenues for the project are given below:

Cost of new equipment $600,000

Working capital needed $90,000

Net annual Cash receipts $85,000

Equipment rebuilding cost Half way thru the contract $130,000

Salvage value of equipmentIn 8 years $30,000

Which method should Pacific Marine services utilize in future analyses of these types of decisions. Explain the pros and cons of using either the net present value method and the simple rate of return method.

Answer 1

Generally in decision making NPV method is considered the best. Even in contradiction with IRR, it is suggested to go with the NPV rule as IRR doesn't take into account the discount rate of investment and therefore is not a practical approach for estimating future cash flows. MIRR approach can be also applied instead of IRR to these type of projects.

Pros:

• With the NPV method, the advantage is that it is a direct measure of the dollar contribution to the stockholders.
• With the IRR method, the advantage is that it shows the return on the original money invested.

Cons:

• With the NPV method, the disadvantage is that the project size is not measured.
• With the IRR method, the disadvantage is that, at times, it can give you conflicting answers when compared to NPV for mutually exclusive projects. The 'multiple IRR problem' can also be an issue, as discussed below.