Question

Pacific

Marine services has

been offered a contract to provide highly classified services to the U.S.

Navy. The contra

ct is for 8 years. The projected costs and revenues for the project are given below:

Cost of new equipment

$6

00,000

Working capital needed

9

0,000

Net annual Cash receipts

85,000

Equipment rebuilding cost

Half way thru the contract

13

0,000

Salvage value of equipment

In 8 years

30,000

A.

Pacific Marine services

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.

B.

Complete the same analysis by using an alternative method of your choice. Should the contract

be accepted based on this analysis.

C.

Which method should

Pacific Marine services

utilize in future

analyses of these types of

decisions. Explain the pros and cons of each method.

Answer 1

A.

Particulars	Y0	Y1	Y2	Y3	Y4	Y5	Y6	Y7	Y8
Initial outlay	600,000
NWC	90,000
Equipment rebuilding cost					(130,000)
Annual cash receipts		85,000	85,000	85,000	85,000	85,000	85,000	85,000	85,000
Salvage value									30,000
Cash flows	(690,000)	85,000	85,000	85,000	(45,000)	85,000	85,000	85,000	115,000
PVF@12%	1	0.893	0.797	0.712	0.636	0.567	0.507	0.452	0.404
PVFA	(690,000)	75,905	67,745	60,520	(28,620)	48,195	43,095	38,420	46,460

NPV = Initial outlay - PV of cash inflows = ($338,280)

Based on NPV, this project should not be accepted as the net return is negative.

B. Lets calculate the IRR of this project. Using excel function, IRR is calculated as

Even the IRR of this project is negative. This project should not be accepted.

C. Generally in decision making NPV method is considered the best. Even in contradiction with IRR, it is suggested to go with the NPV rule as IRR doesn't take into account the discount rate of investment and therefore is not a practical approach for estimating future cash flows. MIRR approach can be also applied instead of IRR to these type of projects

(Student is requested to research the pros and cons of NPV and IRR methods by themselves.