Hearne Company has a number of potential capital investments. Because these proj
ID: 2454749 • 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 $5,650,000. It would generate $1,009,000 in additional net cash flow each year. The new machinery has a useful life of eight years and a salvage value of $1,192,000.
The patent would cost $3,960,000, which would be fully amortized over five years. Production of this product would generate $811,800 additional annual net income for Hearne.
Hearne could purchase 25 new delivery trucks at a cost of $195,000 each. The fleet would have a useful life of 10 years, and each truck would have a salvage value of $6,600. Purchasing the fleet would allow Hearne to expand its customer territory resulting in $999,380 of additional net income per year.
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.)
Project 1: Retooling Manufacturing FacilityThis project would require an initial investment of $5,650,000. It would generate $1,009,000 in additional net cash flow each year. The new machinery has a useful life of eight years and a salvage value of $1,192,000.
Project 2: Purchase Patent for New ProductThe patent would cost $3,960,000, which would be fully amortized over five years. Production of this product would generate $811,800 additional annual net income for Hearne.
Project 3: Purchase a New Fleet of Delivery TrucksHearne could purchase 25 new delivery trucks at a cost of $195,000 each. The fleet would have a useful life of 10 years, and each truck would have a salvage value of $6,600. Purchasing the fleet would allow Hearne to expand its customer territory resulting in $999,380 of additional net income per year.
3.
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.)
4.
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.)
Explanation / Answer
Since there is no tax rate applicable, depreciation tax benefit is not relevant. So, to calculate the net benefit, we have to calculate the present value of future cash flows and compare it with the initial investment.
Project 1
Initial outflow = $5,650,000
Cash flows:
Additional Cash flow each year $1,009,000 for 8 years and
Salvage value of equipment $1,192,000 at the end of 8th year
Present value of cash flows:
= 1,009,000/1.10 + 1,009,000/(1.10)2 + 1,009,000/(1.10)3 + 1,009,000/(1.10)4 + 1,009,000/(1.10)5 + 1,009,000/(1.10)6 + 1,009,000/(1.10)7 + 1,009,000/(1.10)8 + 1,192,000/(1.10)8
= $ 5,939,017.3308
Net benefit after deduction of initial investment
= 5,939,017.3308 - 5,650,000
=$ 289,017.3308
Profitability Index
= PV of future cash flows/ Initial Investment
= $ 5,939,017.3308/5,650,000
= 1.05
Project 2
Initial outflow = $ 3,960,000
Cash flows:
Additional Cash flow each year $ 811,800 for 5 years
Present value of cash flows:
= 811,800/1.10 + 811,800/(1.10)2 + 811,800/(1.10)3 + 811,800/(1.10)4 + 811,800/(1.10)5
= $ 5,451,732.198
Net benefit after deduction of initial investment
= $ 5,451,732.198 - 3,960,000
= $ 1,491,732.198
Profitability Index
= PV of future cash flows/ Initial Investment
= $ 5,451,732.198/3,960,000
= 1.38
Project 3
Initial outflow = $ 195,000 x 25 = $ 4,875,000
Cash flows:
Additional Cash flow each year $ 999,380 for 10 years and
Salvage value of equipment $ 6,600 x 25 = $ 165,000 at the end of 10th year
Present value of cash flows:
= 999,380/1.10 + 999,380/(1.10)2 + 999,380/(1.10)3 + 999,380/(1.10)4 + 999,380/(1.10)5 + 999,380/(1.10)6 + 999,380/(1.10)7 + 999,380/(1.10)8 + 999,380/(1.10)9 + 999,380/(1.10)10 + 165,000/(1.10)10
= $ 6,204,372.1168 - 4,875,000
= $ 1,329,372.1168
Profitability Index
= PV of future cash flows/ Initial Investment
= $ 6,204,372.11/4,875,000
= 1.27
As per profitability Index, the projects are prioritized as follows:
First Priority - Project 2
Second Priority - Project 3
Third Priority - Project 1
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