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 very and nature, initial investment, and time Horizon, management is finding it difficult to compare them. Assume straight-line depreciation method is used.

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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 $4,850,000. It would generate $865,000 in additional net cash flow each year. The new machinery has a useful life of eight years and a salvage value of $1,000,000 Project 2: Purchase Patent for New Product The patent would cost S3,400,000, which would be fully amortized over five years. Production of this product would generate S425,000 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 $115,000 each. The fleet would have a useful life of 10 years, and each truck would have a salvage value of $5,000. Purchasing the fleet would allow Hearne to expand its customer territory resulting in $200,000 of additional net income per year

Explanation / Answer

Hearne Company Accounting rate of return Project 1 Project 2 Project 2 =Income after depreciation/(initial investment-salvage value) =(865000-((4850000-1000000)/8))/4850000% =(425000-(3400000/5))/3400000 =(200000-((2875000-125000)/10))/2875000% Accounting rate of return 7.912371134 -7.5 -2.60869565 Project's payback period Project 1 Project 2 Project 2 =initial investment/annual cash inflow =4850000/865000 =3400000/425000 =2875000/200000 Project's payback period 5.606936416 8 14.375 Project 1 Project 2 Project 2 Nature of cash flow Year Cash flow PVIF@10% Present value Cash flow PVIF@10% Present value Cash flow PVIF@10% Present value Initial cost 0 -4850000 1 -4850000 -3400000 1 -3400000 -2875000 1 -2875000 Cash Inflow 1 865000 0.909090909 786363.6364 425000 0.909090909 386363.6364 200000 0.909090909 181818.1818 Cash Inflow 2 865000 0.826446281 714876.0331 425000 0.826446281 351239.6694 200000 0.826446281 165289.2562 Cash Inflow 3 865000 0.751314801 649887.3028 425000 0.751314801 319308.7904 200000 0.751314801 150262.9602 Cash Inflow 4 865000 0.683013455 590806.6389 425000 0.683013455 290280.7185 200000 0.683013455 136602.6911 5 865000 0.620921323 537096.9444 425000 0.620921323 263891.5623 200000 0.620921323 124184.2646 6 865000 0.56447393 488269.9495 200000 0.56447393 112894.786 7 865000 0.513158118 443881.7723 200000 0.513158118 102631.6236 8 1865000 0.46650738 870036.2641 200000 0.46650738 93301.47604 9 200000 0.424097618 84819.52367 10 325000 0.385543289 125301.5691 Net Present Value 231218.5414 -1788915.62 -1597893.67 Present Value Index Project 1 Project 2 Project 2 =Total Inflows/Total outflows Total Inflow 5081218.541 1611084.377 1277106.332 Total outflow 4850000 3400000 2875000 Present Value Index 1.047673926 0.473848346 0.444210898 Conclusion : Only project 1 should be selected

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