5. Capital budgeting Golden Flights, Inc., is considering buying some specialize

Question

5. Capital budgeting
Golden Flights, Inc., is considering buying some specialized machinery that would enable the company to obtain a six-year government contract for the design and engineering of a futuristic plane. The machinery costs $975,000 and must be destroyed for security reasons at the end of the six-year contract period. The estimated annual operating results of the project are as follows:

All revenue from the contract and all expenses (except depreciation) will be received or paid in cash in the same period as recognized for accounting purposes. You are to compute the following three factors for this project:

(a) Payback period: __________ years

(b) Return on average investment: __________%

(c) Net present value of the investment in this machinery, discounted at an annual rate of 12% (an annuity table shows that the present value of $1 received annually for six years discounted at 12% is 4.111): $__________

Explanation / Answer

Solution:

(a) Payback Period ---- Payback period is the length of time whithin which initial invenstment is returned back to the company.

Payback Period considers the Cash flows..

Hence, Annual Cash Flow = Net Income + Depreciation = $252,500 + $162,500 = $415,000

Initial Investment = $975,000

Payback Period = Initial Investment / Annual Cash Flow = $975,000 / $415,000 = 2.35 years

(b) Return on Average Investment = Average Annual Net Income after depreciation and taxes / Average Investment x 100

Average Annual Net Income after depreciation and taxes (given) = $252,500

Average Investment = (Value of Investment at beginning + Value of Investment at end) / 2 = ($975,000 + $0) / 2 = $487,500

Value of Investment at end = $0 because there is no salvage value given in the question

Return on Average Investment = $252,500 / $487,500 x 100 = 51.80%

(C) Net Present Value = Present Value of Cash Flows - Present Value of Cash OUtlfow

Present Value of Cash Flows = Annual Cash Flow x PVIFA (12%, 6) = $415,000 x 4.111 = $1,706,065

Present Value of Cash Outflow = Initial Investment = $975,000

Net Present Value = $1,706,065 - $975,000 = $731,065

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