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	$36,100		$112,000			$76,000		$179,000
2	36,100		112,000			58,000		151,000
3	36,100		112,000			29,000		106,000
4	36,100		112,000			13,000		73,000
5	36,100		112,000			4,500		51,000
Total	$180,500		$560,000			$180,500		$560,000

Each project requires an investment of $380,000. 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, 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 greater net present value because greater cash flows occur earlier in time compared to the greenhouse. Thus, if only one of the two projects can be accepted, the front-end loader would be the more attractive.

Answer 1

Answer to Part 1a.

Average Rate of Return = Average Annual Income / Average Investment * 100

Front-End Loader:

Average Annual Income = (36,100 + 36,100 + 36,100 + 36,100 + 36,100)/5
Average Annual Income = $36,100

Average Investment = (380,000 + 0) / 2 = $190,000

Average Rate of Return = 36,100 / 190,000 * 100
Average Rate of Return = 19%

Green House Loader:

Average Annual Income = (76,000 + 58,000 + 29,000 + 13,000 + 4,500)/5
Average Annual Income = $36,100

Average Investment = (380,000 + 0) / 2 = $190,000

Average Rate of Return = 36,100 / 190,000 * 100
Average Rate of Return = 19%

Answer to Part 2.

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