Question

Average Rate of Return Method, Net Present Value Method, and Analysis for a service company

The capital investment committee of Arches Landscaping Company is considering two capital investments. The estimated operating income and net cash flows from each investment are as follows:

	Front-End Loader					Greenhouse
Year	Operating Income		Net Cash Flow			Operating Income		Net Cash Flow
1	$54,600		$164,000			$115,000		$262,000
2	54,600		164,000			87,000		221,000
3	54,600		164,000			44,000		156,000
4	54,600		164,000			19,000		107,000
5	54,600		164,000			8,000		74,000
Total	$273,000		$820,000			$273,000		$820,000

Each project requires an investment of $520,000. Straight-line depreciation will be used, and no residual value is expected. The committee has selected a rate of 12% for purposes of the net present value analysis.

Present Value of $1 at Compound Interest
Year	6%	10%	12%	15%	20%
1	0.943	0.909	0.893	0.870	0.833
2	0.890	0.826	0.797	0.756	0.694
3	0.840	0.751	0.712	0.658	0.579
4	0.792	0.683	0.636	0.572	0.482
5	0.747	0.621	0.567	0.497	0.402
6	0.705	0.564	0.507	0.432	0.335
7	0.665	0.513	0.452	0.376	0.279
8	0.627	0.467	0.404	0.327	0.233
9	0.592	0.424	0.361	0.284	0.194
10	0.558	0.386	0.322	0.247	0.162

Required:

1a. Compute the average rate of return for each investment. If required, round your answer to one decimal place.

	Average Rate of Return
Front-End Loader	%
Greenhouse	%

1b. Compute the net present value for each investment. Use the present value of $1 table above. If required, round to the nearest dollar. If required, use the minus sign to indicate a negative net present value.

	Front-End Loader	Greenhouse
Present value of net cash flow	$	$
Amount to be invested
Net present value	$	$

2. Prepare a brief report for the capital investment committee, advising it on the relative merits of the two investments.

The front-end loader has a   net present value because cash flows occur   in time compared to the greenhouse. Thus, if only one of the two projects can be accepted, the   would be the more attractive.

Answer 1

1a. Compute the average rate of return for each investment. If required, round your answer to one decimal place.

	Average Rate of Return
Front-End Loader	54600/260000 = 21%
Greenhouse	21%

1b. Compute the net present value for each investment. Use the present value of $1 table above. If required, round to the nearest dollar. If required, use the minus sign to indicate a negative net present value.

	Front-End Loader	Greenhouse
Present value of net cash flow	$164000*3.605 = 591220	$631185
Amount to be invested	-520000	-520000
Net present value	$71220	$111185

2. Prepare a brief report for the capital investment committee, advising it on the relative merits of the two investments.

The front-end loader has a lower net present value because cash flows occur evenly in time compared to the greenhouse. Thus, if only one of the two projects can be accepted, the greenhouse would be the more attractive.