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	$44,000		$139,000			$92,000		$222,000
2	44,000		139,000			70,000		188,000
3	44,000		139,000			35,000		132,000
4	44,000		139,000			15,000		90,000
5	44,000		139,000			8,000		63,000
Total	$220,000		$695,000			$220,000		$695,000

Each project requires an investment of $440,000. 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, 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 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

	Average rate of return=			Average annual income/Average investment
						Front loader		Greenhouse
	Average annual income = income/total years					44000		44000
	Average investment =(0+investment)/2					220000		220000
	Average rate of return					20%		20%
1a)				Average rate of return
	Front-end loader			20%
	Greenhouse			20%
1b)				Front end		Greenhouse
	Present value of net cash flow			526810		556811
	Amount to be invested			440,000		440,000
	Net present value			86,810		116,811
	Front end					Green house
	year	cash flow	Factor	PV		year	cash flow	Factor	PV
	1	139,000	0.909	126351		1	222,000	0.909	201798
	2	139,000	0.826	114814		2	188,000	0.826	155288
	3	139,000	0.751	104389		3	132,000	0.751	99132
	4	139,000	0.683	94937		4	90,000	0.683	61470
	5	139,000	0.621	86319		5	63,000	0.621	39123
	present value of net cash flow			526810		present value of net cash flow			556811
	The front load runner has a lower net present value as greeh house cash flow occur earlier
	in time.Thus if only one of the two projects can be accepted , the greenhouse would
	be more attractive.