Mojo Marine services has been offered a contract to provide highly classified se

Question

Mojo Marine services has been offered a contract to provide highly classified services to the U.S. Navy. The contract is for 8 years. The projected costs and revenues for the project are given below: $500,000 100,000 Cost of new equipment Working capital needed Net annual Cash receipts Equipment rebuilding cost 90,000 Half way thru the contract 150,000 Salvage value of equipment In 8 years 50,000 A. Mojo's cost of capital is 12 percent. Complete an analysis to determine whether or not this contract should be accepted by utilizing the Net Present Value Method. Should the contract be accepted? Explain, Show all your calculations in good form. Simple rate of return B. Complete the same analysis by usingShould the contract be accepted based on this analysis. C. Which method should Mojo Marine utilize in future analyses of these types of decisions. Explain the pros and cons of each method.

Explanation / Answer

a.

Project should not be accepted because NPV is negative.

B. Total cash out flows = 500000+100000+150000=$750000

Total cash inflows= 90000X8 + 50000 = $770000

simple rate of return = cash inflow/invetment/cash outflow - 1
=770000/750000 - 1
=2.67% of return

Company should not accept the project because the simple rate of return on investment is less than the company cost of capital i.e minimum rate of return.

c.

The simple rate of return is an excessively simplistic method to use for judging a capital budgeting request. The method does not use discounting to reduce the incremental amount of net income to its present value. Instead, it assumes that any net income earned during the measurement period is the same as its present value.

NPV method should be Used

Pros of simple rate of return

1. Rate of return method is very simple and easy to understand

2. Its use is easy.

3. Rate of return may readily be calculated with the help of accounting data.

4.The simple rate of return will be fairly close to the true rate of return in investment with extremely long lives. It may be used to measure the current performance of a firm.

Cons of simple rate of return

(1) Rate of return method uses accounting profits and not the cash inflows in appraising the investment projects.

(2) It ignores the time value of money which is an important factor in capital expenditure decisions.

(3) Rate of return method considers only the rate of return and not the length of project lives.

(4) It ignores the fact that profits can be re-invested and profits can be earned on such investment, which in turn will affect the rate of return.

Pros of NPV

Cons of NPV

1. More complicated method – users may find it hard to understand

2. Difficult to select the most appropriate discount rate – may lead to good projects being rejected

3.The NPV calculation is very sensitive to the initial investment cost

NPV= PVCI-PVCO PVCI = PRESENT VALUE OF CASH INFLOW PVCO = PV OF CASH OUTFLOW PVCI = PV X CASH INFLOW PV= 1/(1+R)^N

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