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 income from operations and net cash flows from each investment are as follows:

	Front-End Loader					Greenhouse
Year	Income from Operations		Net Cash Flow			Income from Operations		Net Cash Flow
1	$40,000		$120,000			$84,000		$192,000
2	40,000		120,000			64,000		162,000
3	40,000		120,000			32,000		114,000
4	40,000		120,000			14,000		78,000
5	40,000		120,000			6,000		54,000
Total	$200,000		$600,000			$200,000		$600,000

Each project requires an investment of $400,000. Straight-line depreciation will be used, and no residual value is expected. The committee has selected a rate of 10% 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, 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 smaller net present value because cash flows occur later in time compared to the greenhouse. Thus, if only one of the two projects can be accepted, the greenhouse would be the more attractive.

Answer 1

ans 1
Average rate of return=average profit/average investment*100
	Front end loader		Greenhouse
Total income from operations	$200,000		200000
No. of years	5		5
Average profit A	$40,000		$40,000
Av erage investment B	$200,000		$200,000
(initial investment+salvage value)/2	(400000+0)/2
answer
ARR A/B	20		20	%
Average Rate of Return
Front-End Loader	20	%
Greenhouse	20	%
ans 2
Front-End Loader
Year	Net Cash	Discount factor	Discounted cash flow
	Flow	10%
1	$120,000	0.909	$109,080
2	120,000	0.826	$99,120
3	120,000	0.751	$90,120
4	120,000	0.683	$81,960
5	120,000	0.621	$74,520
Total	$600,000		$454,800
Greenhouse
Year	Net Cash	Discount factor	Discounted cash flow
	Flow	10%
1	$192,000	0.909	$174,528
2	162,000	0.826	$133,812
3	114,000	0.751	$85,614
4	78,000	0.683	$53,274
5	54,000	0.621	$33,534
Total	$600,000		$480,762
	Front-End Loader	Greenhouse
Present value of net cash flow	$454,800	$480,762
Amount to be invested	400000	400000
Net present value	$54,800	$80,762
ans 2
smaller
later
greenhouse
If any doubt please comment