Question

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

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.

Solutions

Expert Solution

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.


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