Hearne Company has a number of potential capital investments. Because these proj
ID: 2451802 • Letter: H
Question
Hearne Company has a number of potential capital investments. Because these projects vary in nature, initial investment, and time horizon, management is finding it difficult to compare them. Assume straight line depreciation method is used.
This project would require an initial investment of $5,550,000. It would generate $991,000 in additional net cash flow each year. The new machinery has a useful life of eight years and a salvage value of $1,168,000.
The patent would cost $3,890,000, which would be fully amortized over five years. Production of this product would generate $758,550 additional annual net income for Hearne.
Hearne could purchase 25 new delivery trucks at a cost of $185,000 each. The fleet would have a useful life of 10 years, and each truck would have a salvage value of $6,400. Purchasing the fleet would allow Hearne to expand its customer territory resulting in $901,900 of additional net income per year.
Determine each project's accounting rate of return. (Round your answers to 2 decimal places.)
Determine each project's payback period. (Round your answers to 2 decimal places.)
Using a discount rate of 10 percent, calculate the net present value of each project. (Future Value of $1, Present Value of $1, Future Value Annuity of $1, Present Value Annuity of $1.) (Use appropriate factor(s) from the tables provided. Round your intermediate calculations to 4 decimal places and final answers to 2 decimal places.)
Determine the profitability index of each project and prioritize the projects for Hearne. (Round your intermediate calculations to 2 decimal places. Round your final answers to 4 decimal places.)
Hearne Company has a number of potential capital investments. Because these projects vary in nature, initial investment, and time horizon, management is finding it difficult to compare them. Assume straight line depreciation method is used.
Explanation / Answer
1. Computation of Accounting rate of return of each project
Accounting Rate of Return = Annual Average income / Original investment * 100
Project 1 :
Years Cash inflows Depreciation Earnings after depreciation
1 991000 547750 443250
2 991000 547750 443250
3 991000 547750 443250
4 991000 547750 443250
5 991000 547750 443250
6 991000 547750 443250
7 991000 547750 443250
8 991000 547750 443250
Depreciation = cost of asset - salvage value / estimated life of asset
= 5550000 - 1168000 / 8 = 547750
Annual average income = 443250 * 8 / 8 = 443250
Original investment = 5550000 - 1168000 /2 + 1168000
= 3359000
ARR = 443250 / 3359000 * 100 = 13.2 %
Project 2 :
annual average income = 758550 / 5 = 151710
Original investment = 3890000 / 2 = 1945000
ARR = 151710 / 1945000 * 100 = 7.8%
Project 3 :
Annual average net income = 901900 * 10 / 10 = 901900
original investment = 4625000 - 160000 / 2 + 160000
= 2232500 + 160000 = 2392500
ARR = 901900 / 2392500 * 100 = 37.7%
2. Computation of Payback period of each project
Years Project 1 CCF* Project 2 CCF Project 3 CCF
1 991000 991000 758550 758550 901900 901900
2 991000 1982000 758550 1517100 901900 1803800
3 991000 2973000 758550 2275650 901900 2705700
4 991000 3964000 758550 3034200 901900 3607600
5 991000 4955000 758550 3792750 901900 4509500
6 991000 5946000 901900 5411400
7 991000 6937000 901900 6313300
8 991000 7928000 901900 7215200
9 901900 8117100
10 901900 9019000
* = Cummulative cash flows
Payback period :
Project A = 5+ 595000 / 991000 = 5 + 0.6 = 5.6 years
Project B = no pay back period because cash flows done in more than pay back period
Project C = 5+ 115500 / 901900 = 5+ 0.13 = 5.13 years
3. Computation of NPV
Years Project 1 discount@10 PV cash flows Project2 PV cashflows Project 3 PV cash flows
1 991000 0.909 900819 758550 689522 901900 819827
2 991000 0.826 818566 758550 626562 901900 744969
3 991000 0.751 744241 758550 569671 901900 677327
4 991000 0.683 676853 758550 518090 901900 615998
5 991000 0.621 615411 758550 471060 901900 560080
6 991000 0.565 559915 901900 509574
7 991000 0.513 508383 901900 462675
8 991000 0.467 462797 901900 421187
9 991000 0.424 901900 382406
10 991000 0.386 901900 348133
Total PV cash inflows 5286985 2874905 5542176
less initial investment (5580000) (3890000) (4625000)
NPV (293015) (1015095) 917176
4. Computation of profitability Index
Profitability Index = PV cash inflows / PV cash outflows
Project 1 = 5286985 / 5580000 = 0.95
Project 2 = 2874905 / 3890000 = 0.74
Project 3 = 5542176 / 4625000 = 1.20.
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