Question

Ramona Company has been offered a eight-year contract to supply a part for the government. After careful study, the company has estimated the following data relating to the contract: Cost of Equipment Needed Working Capital Needed Annual Cash Receipts from the Delivery of Parts Annual Cash Operating Costs Salvage Value of Equipment at Termination of the Contract $200,000 50,000 100,000 30,000 5,000 It is not expected that the contract would be extended beyond the initial contract period. The company's discount rate is 12%. (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 Company requires a three-year payback period. 3) Calculate the Accrual Accounting Rate of Return. 4) Given your calculations, should GH Company accept the contract? 1 / 1 View as Text D

Answer 1

X fax 1) B C E F G H I J K L M N O P cost of equipment working capital introduced initial cash outflow $ 200,000 $ 50,000 $ 250,000 annual net cash inflow annual depreciation annual net income $ 70,000 24375 $ 45,625 average investment $ 102,500 annual cash receipts $ 100,000 annual cash operating costs $ 30,000 annual net cash inflow $ 70,000 *) present value annuity factor (12%, 8 years 4.96764 El present value of annual net cash inflows | $ 347,735 accrual accounting rate of return = annual net income / average investment accrual accounting rate of return = $45,625 / $102,500 accrual accounting rate of return = | 44.51% salvage value present value factor (12%, 8 years El present value of annual net cash inflows $5,000 0.40388 $ 2,019 decision - GH Company should accept the contract. reason - because the net present value is positive and the payback period is less than 3 years. + present value of annual net cash inflows present value of annual net cash inflows initial cash outflow $ 347,735 $ 2,019 $ 250,000 $ 99,754 net present value decision - the contract should be accepted reason - because the net present value is positive 2) payback period = cost of equipment/ annual cash inflows payback period = $200,000 / $70,000 payback period = 2.86 years

for formulas and calculations, refer to the image below -

X fx 1) F G H I J K L M N O P 3)T cost of equipment working capital introduced initial cash outflow 200000 50000 =E2+E3 annual net cash inflow annual depreciation annual net income =E8 =(200000-5000)/8 = 12-13 average investment =(E2+E12)/2 annual cash receipts 100000 annual cash operating costs 30000 annual net cash inflow =E6-E7 * present value annuity factor (12%, 8 years --PV(12%,8,1) = present value of annual net cash inflows =ROUND(E8*E9,0) accrual accounting rate of return = annual net income / average investment accrual accounting rate of return = $45,625 / $102,500 accrual accounting rate of return = -45625/102500 salvage value present value factor (12%, 8 years = present value of annual net cash inflows 5000 --PV(12%,8,0,1) =ROUND(E12*E13,0) decision - GH Company should accept the contract. reason - because the net present value is positive and the payback period is less than 3 years. present value of annual net cash inflows =E10 + present value of annual net cash inflows =E14 initial cash outflow =E4 net present value =E16+E17-E18 decision - the contract should be accepted reason - because the net present value is positive 2) payback period = cost of equipment/ annual cash inflows payback period = $200,000 / $70,000 payback period = =200000/70000 years

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