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 $9?5,U-i] and must be destroyed for security reasons at the end of the sixyear contract period. The estimated annual operating results of the project are as follows: Revenue from sales underthe contract ......................... - $9T5,l} Expenses other than depreciation _________________________________ $5'El},i}|l} _ Depreciation {straightline Eggs}, EH H H, gm: H H H! H H 162 Still {22,500} Increase in net income from government contract _________ _ 5252 Still} All revenue from the contract and all expenses {except depreciation] will be received or paid in cash in the same pen'od as recognized for accounting purposes. You are to compute the following three factors for this project: a. Payback period: 2.35 years Amount to be invested $975,000 : 2.35 Estimated annual net cash flows $415,000 b. Return on average investment: 52 % $975,000 Average investment = Original cost + Salvage value = = $487,500 2 2 Average estimated net income $252,500 = = 0.52 Average investment $487,500 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): $ Present value of expected annual cash flows ($415,000 x 4.111) $1.706.065 Cost of investment 975,000 Net present value of proposed investment $731,065