Question

GH Inc. has been offered a five-year contract to supply security for a local university. After careful study, the company has estimated the following data relating to the contract:
Cost of Equipment Needed $250,000. Working Capital Needed 25,000. Annual Cash Receipts from the Delivery of Services 140,000. Annual Cash Operating Costs 90,000. Salvage Value of Equipment at Termination of the Contract 10,000.
It is not expected that the contract would be extended beyond the initial contract period. The company's discount rate is 9%. (Ignore income taxes in this problem.)
Required:
1) Use the net present value method to determine if the contract should be accepted. Round all computations to the nearest dollar.
2) Use the payback method to determine if the contract should be accepted. Assume GH Inc. requires a seven-year payback period.
3) Calculate the Simple Rate of Return.
4) Given all of your calculations, should GH Inc. accept the contract?

Answer 1

Initial Investment :
Investment required	$  250,000.00
Working capital required	$    25,000.00
Initial Investment =	$  275,000.00
Net cash Inflows = $140,000 - $90,000	$    50,000.00
Depreciation = ($250,000 - $10000)/5	$    48,000.00
Net  operating cash Inflows =	$    98,000.00
Year 5 cash flows = $98000 + 250000+10000	$  133,000.00
a)
Year	Cash Flows	PV @ 9%	Present Value
0	$ (275,000.00)	1	$ (275,000.00)
1	$    98,000.00	0.91743	$    89,908.26
2	$    98,000.00	0.84168	$    82,484.64
3	$    98,000.00	0.77218	$    75,673.98
4	$    98,000.00	0.70843	$    69,425.67
5	$  133,000.00	0.64993	$    86,440.87
		NPV	$       128,933
The contract should be accepted since NPV is positive
b)
Pay back period = Initial investment/ Annual net operating cash flow
Pay back period = 275000/98000	2.81	years
The contract should be accepted since Payback period is less than 7 years
c) Simple Rate of Return = Net  cash inflows/Initial investment
Simple rate of return = $50,000/275000	18.18%
d) GH inc. should accept the contract  because NPV is positive , Payback period is less than 7 years and rate of return is 18.18%