Managerial Accounting – BADM 2010

F18
Assignment 8 Chapter 18

GH Company has been offered a seven-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 $300,000

Working Capital Needed 50,000
Annual Cash Receipts from the Delivery of Parts 100,000
Annual Cash Operating Costs 30,000
Salvage Value of Equipment at Termination of the Contract 5,000
 
It is not expected that the contract would be extended beyond the initial contract
period. The company's discount rate is 10%. (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 four-year payback period.
3) Calculate the Accrual Accounting Rate of Return.
4) Given your calculations, should GH Company accept the contract?
Solution:

1) Description Years Amount 10% Factor Present Value

Purchase 0 ($300,000) 1.000 ($300,000)
Working Capital 0 ( 50,000) 1.000 ( 50,000)
Release of W.C. 7 ( 50,000) 0.513 25,650
Net annual cash flow 1-7 70,0001 4.868 340,760
Salvage value 7 5,000 . 0.513 2,565
Net present value $ 18,975
1
Net annual cash flow = Annual cash receipts – Annual cash costs
= $100,000 - $30,000
= $70,000

NPV is positive. Therefore, make the investment.

2) Payback period = Investment/Annual cash inflows

= ($300,000+$50,000)/$70,000 per year
= 5 years
A four-year payback period is required. Therefore, reject the investment.

3) Depreciation Expense = (Cost of Equipment - Estimated Salvage Value)/Estimate Life

= ($300,000-$5,000)/7 years
= $42,143 per year

Accrual Accounting Rate of Return = Operating Income/Operating Investment

= ($70,000 - $42,143)/($300,000-$5,000)
= 0.094 or 9.4%

OR

Accrual Accounting Rate of Return = Operating Income/Operating Investment

= ($70,000 - $42,143)/($300,000)
= 0.0929 or 9.3%

No criteria were given for the accrual accounting rate of return. Therefore, a decision on
this investment cannot be made using this method.

4) The contract should be accepted because NPV is the superior to the payback period. NPV
uses the time value of money; payback does not.