Average Rate of Return Method, Net Present Value Method, and Analysis for a serv

Question

Average Rate of Return Method, Net Present Value Method, and Analysis for a service company

The capital investment committee of Arches Landscaping Company is considering two capital investments. The estimated income from operations and net cash flows from each investment are as follows:

Each project requires an investment of $420,000. Straight-line depreciation will be used, and no residual value is expected. The committee has selected a rate of 15% for purposes of the net present value analysis.

Required:

1a. Compute the average rate of return for each investment. If required, round your answer to one decimal place.

1b. Compute the net present value for each investment. Use the present value of $1 table above. If required, use the minus sign to indicate a negative net present value.

2. Prepare a brief report for the capital investment committee, advising it on the relative merits of the two investments.

The front-end loader has a smaller net present value because cash flows occur earlier in time compared to the greenhouse. Thus, if only one of the two projects can be accepted, the greenhouse would be the more attractive.

Front-End Loader Greenhouse Year Income from
Operations Net Cash
Flow Income from
Operations Net Cash
Flow 1 $42,000 $137,000 $88,000 $219,000 2 42,000 137,000 67,000 185,000 3 42,000 137,000 34,000 130,000 4 42,000 137,000 15,000 89,000 5 42,000 137,000 6,000 62,000 Total $210,000 $685,000 $210,000 $685,000

Explanation / Answer

Solution 1a:

Average rate or return = Average annual income / Average investment

Average investment = ($420,000 + 0) / 2 = $210,000

Average annual income - Front end loader = $210,000 / 5 = $42,000

Average annual income - Greenhouse = $210,000 / 5 = $42,000

Average rate of return - Front end loader = $42,000 / $210,000 = 20%

Average rate of return - Greenhouse = $42,000 / $210,000 = 20%

Solution 1b:

Solution 2:

The front-end loader has a smaller net present value because cash flows occur earlier in time compared to the greenhouse. Thus, if only one of the two projects can be accepted, the greenhouse would be the more attractive

Computation of Present Value of cash Inflows Particulars Period PV factor Frontend loader Greenhouse Amount Present Value Amount Present Value Cash inflows: Year 1 1 0.870 $137,000.00 $119,190.00 $219,000.00 $190,530.00 Year 2 2 0.756 $137,000.00 $103,572.00 $185,000.00 $139,860.00 Year 3 3 0.658 $137,000.00 $90,146.00 $130,000.00 $85,540.00 Year 4 4 0.572 $137,000.00 $78,364.00 $89,000.00 $50,908.00 Year 5 5 0.497 $137,000.00 $68,089.00 $62,000.00 $30,814.00 Present value of cash inflows $459,361.00 $497,652.00

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