Bowman Corporation is considering an investment in special-purpose equipment to

Question

Bowman Corporation is considering an investment in special-purpose equipment to enable the company to obtain a fve-year govemment contract for the manufacture of a special item. The equipment costs $450,000 and would have no savage 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 Expenses other than depreciation Depreciation (straight-ine basis) $630,000 90,000 495,000 s135,000 s 405,000 Increase in net income from contract work All revenue and all expenses other than depreciation will be received or paid in cash in the same period as recognized for accounting purposes. a. Compute the payback period for Bowman's proposal to undertake the contract work: Payback period 2 years b. Compute the retum on average investment for Bowman's proposal to undertake the contract work: Retum on average investment c. Compute the net present value of the proposal to undertake contract work, discounted at an annual rate of 12 percent. (Refer to annuity table in Exhibit 26-4.) (Round your "PV factor to 3 decimal places) Net present value

Explanation / Answer

Solution:

a) Calculation of payback period:

Equipment costs = 450,000

Net Income including Depreciation = 135,000 + 90,000 = 225,000

Payback Period = 450,000/ 225,000 = 2 Years

b) Calculation of Return on Average Investment:

Average Investment = 450,000/2 = 225,000

Net Income = 135,000

Return on Average Investment = 135,000/ 225,000

= 0.60

= 60%

c) Calculation of Net Present Value:

Initial Investment = 450,000

Yearly increase in cash flows = 225,000

Discounted at an annual rate of 12% (an annuity table shows that the present value of $1 received annually for 5 years discounted at 12% is 3.605)

NPV = (Annual CF x Disc Factor) - Initial Investment

= (225,000 * 3.605) – 450,000

= 811,125 – 450,000

= 361,125

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