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 $5,350,000. It would generate $955,000 in additional net cash flow each year. The new machinery has a useful life of eight years and a salvage value of $1,120,000.

Project 2: Purchase Patent for New Product

The patent would cost $3,750,000, which would be fully amortized over five years. Production of this product would generate $656,250 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 $165,000 each. The fleet would have a useful life of 10 years, and each truck would have a salvage value of $6,000. Purchasing the fleet would allow Hearne to expand its customer territory resulting in $721,900 of additional net income per year.


Required:
1. Determine each project's accounting rate of return. (Round your answers to 2 decimal places.)

       

2. Determine each project's payback period. (Round your answers to 2 decimal places.)

       

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

Answer 1 :

Accounting rate of return (ARR) = average annual return/(Average investment)

Depreciation amount every year: (5350000-1120000)/8 = 528750

Average annual return : 955000- 528750 = $426250

Average investment : 0.5*(5350000+1120000) = 3235000

ARR = 426250/3235000 = 13.17%

Payback period for this project :(total investment / net cash flow each year) : 5350000/955000 = 5.6 years

NPV : PV of annual cash flows = 955000*PVIFA(10,8) = 955000*5.3349 =$5094830

PV of salvage value = 1120000 *PVIF(10,8) =1120000 *0.4665 = 522480

Total PV of cah inflows : 5094830 + 522480 - initial investment(5350000) = $267309.5

Profitability index = PV OF CASH INFLOWS / INITIAL INVESTMENT = 5617310 /5350000 = 1.049

For project 2:

ARR : 656250/(0.5*3750000)= 0.35 = 35 %

Payback period : 3750000/1406250 ( 656250 + amortized amount every year)

payback period = 2.66 years

NPV =annual cash flow =1406250

PV of annual cash flow =1406250 * PVIFA (10,5) = 1406250* 3.7908 =$5330813

less initial investment : 3750000

NPV = 1580813

profitability index: 5330813/3750000 = 1.421

Project 3:

ARR :

Average Annual income : $721900

Average investment : 25*(165000+6000)/2 = 2137500

ARR : = 721900/2137500 = 33.77%

Payback period : annual cash flow : 721900 + 25*(165000-6000)/10 = 1119400

Investment = 25*165000/1119400 : 3.68 years

PV of annual cash flows: 1119400*PVIFA(10,10) = 1119400 *6.1446 = 6878265

PV of residual value : 6000*25/(1.1)^10 = 57831.49

total PV - initial investment = 6878265 + 57831.49 - (25*165000) =2811097

PI Index = 6936097/25*165000 = 1.6814

Under NPV project 1 has rank 3

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