Hearne Company has a number of potential capital investments. Because these proj

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 Project 1: Retooling Manufacturing Facility This project would require an initial investment of $4,950,000. It would generate $883,000 in additional net cash flow each year. The new machinery has a useful life of eight years and a salvage value of $1,024,000. Project 2: Purchase Patent for New Product The patent would cost $3,470,000, which would be fully amortized over five years. Production of this product would generate $468,450 additional annual net income for Hearne. Project 3: Purchase a New Fleet of Delivery Trucks Hearne could purchase 25 new delivery trucks at a cost of $125,000 each. The fleet would have a useful life of 10 years, and each truck would have a salvage value of $5,200. Purchasing the fleet would allow Hearne to expand its customer territory resulting in $421,900 of additional net income per year. Required: 1. Determine each project's accounting rate of return. (Round your answers to 2 decimal places.) Accounting Rate of Return Project 1 Project 2 Project 3 13.50 %

Explanation / Answer

Solution:

1) Accounting Rate of Return

Accounting Rate of return measures the average annual net income of the project in % term of proposed investment.

Accounting Rate of Return = Average Annual Net Income after Depreciation and Taxes / Initial Investment x 100

Project 1

Project 2

Project 3

Initial Investment (A)

$4,950,000

$3,470,000

$3,125,000

Net Cash Flow each year

$883,000

Less: Depreciation

($490,750)

Net Income

$392,250

$468,450

$421,900

Accounting Rate of Return

(Average Annual Net Income after Depreciation and Taxes / Initial Investment)

7.92%

13.50%

13.50%

Note --- Net Income is given for Project 2 and Project 3. We need to calculate Net Income of Project 1 because for project 1 Annual Cash Flow is given. Accounting Rate of Return does not consider Cash Flow. It is calculated by using Net Income after depreciation and taxes. That is why we subtract the depreciation from cash flow. Net Income = Cash Flow – Depreciation

Note --- Depreciation for Project 1 = ($4950000 - 1024000)/8 = $490,750

2) Payback Period

Payback Period is the length of time within which initial investment are returned back to the company.

Payback Period = Initial Investment / Annual Cash Flow

Annual Cash Flow = Net Income + Depreciation

Project 1

Project 2

Project 3

Initial Investment

$4,950,000

$3,470,000

$3,125,000

Net Income

$468,450

$421,900

Add: Depreciation/Amortization

$694,000

$299,500

Annual Cash Flow

$883,000

(Given)

$1,162,450

$721,400

Payback Period

(Initial Investment / Annual Cash Flow)

5.61 Years

2.99 Years

4.33 Years

Note 3: Depreciation / Amortization

Project 2 ---- ($3,470,000 – 0) / 5 = $694,000

Project 3 ---- 25 x ($125,000 – 5,200) / 10 = $299,500

3) Net Present Value (Using discounting rate 10%)

Net Present Value = Present Value of Cash Flow – Present Value of Cash Outflow

Project 1

Project 2

Project 3

Present Value of Cash Outflow (Initial Investment) (A)

$4,950,000

$3,470,000

$3,125,000

Life in years

8

5

10

Calculation of Present Value of Cash Flow

Annual Cash Flow

$883,000

$1,162,450

$721,400

PVIFA (10%, life)

5.3349

3.7908

6.1445

Present Value of Cash Flow (B)

$4,710,717

$4,406,615

$4,432,642

Salvage Value at the end of life

$1,024,000

0

$130,000

PVIF (10%, life)

0.4665

0.6209

0.3855

PV of Salvage Value ( C)

$477,696

$0

$50,115

Total Present Value of Cash Flow (B + C)

$5,188,413

$4,406,615

$4,482,757

Net Present Value (A - B)

$238,412.70

$936,615.46

$1,357,757.30

4) Profitability Index = Present Value of Cash Flow / Present Value of Cash Outflow

Project 1

Project 2

Project 3

Total Present Value of Cash Flow

$5,188,412.70

$4,406,615.46

$4,482,757.30

Present Value of Cash Outflow

$4,950,000

$3,470,000

$3,125,000

Profitability Index

(Present Value of Cash Flow / Present Value of Cash Outflow)

1.05

1.27

1.43

Project 1

Project 2

Project 3

Initial Investment (A)

$4,950,000

$3,470,000

$3,125,000

Net Cash Flow each year

$883,000

Less: Depreciation

($490,750)

Net Income

$392,250

$468,450

$421,900

Accounting Rate of Return

(Average Annual Net Income after Depreciation and Taxes / Initial Investment)

7.92%

13.50%

13.50%

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