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	$59,400		$181,000			$125,000		$290,000
2	59,400		181,000			95,000		244,000
3	59,400		181,000			48,000		172,000
4	59,400		181,000			21,000		118,000
5	59,400		181,000			8,000		81,000
Total	$297,000		$905,000			$297,000		$905,000

Each project requires an investment of $540,000. 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	59400/270000 = 22%
Greenhouse	22%

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	$181000*3.605 = 652505	$696877
Amount to be invested	-540000	-540000
Net present value	$112505	$156877

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 Lowest 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 Greehouse would be the more attractive.