Morningside Machine Works has obtained a subcontract from the government to manufacture special parts for a new military aircraft. The parts are to be delivered over the next five years, and the company will be paid as the parts are delivered.
To make the parts, Morningside Machine Works will have to purchase new equipment. Two types are available. Type A is conventional equipment that can be put into service immediately; Type B requires one year to be put into service but is more efficient than Type A. Type A requires an immediate cash investment of $1,000,000 and will produce enough parts to provide net cash receipts of $340,000 each year for the five years. Type B may be purchased by signing a two-year non-interest-bearing note for $1,346,000. It is projected that Type B will produce net cash receipts of zero in year 1, $500,000 in year 2, $600,000 in year 3, $600,000 in year 4, and $200,000 in year 5. Neither type of equipment can be used on other contracts nor will neither type have any useful life remaining at the end of the contract. Morningside currently pays an interest rate of 16 percent to borrow money.
1. What is the present value of the investment required for each type of equipment? (Use Table 3 in the appendix on future value and present value tables.)
2. Compute the net present value of each type of equipment based on your answer in 1 and the present value of the net cash receipts projected to be received. (Use Tables 3 and 4 in the appendix on future value and present value tables)
3. Write a memorandum to the board of directors that recommends the option that appears to be best for Morningside. Explain your reasoning and include 1 and 2 as attachments.