Question

Hearne Company has a number of potential capital investments. Because these projects vary in nature, initial investment, and time horizon, management is finding it difficult to compare them. Assume straight line depreciation method is used.   

Project 1: Retooling Manufacturing Facility

This project would require an initial investment of $5,800,000. It would generate $1,036,000 in additional net cash flow each year. The new machinery has a useful life of eight years and a salvage value of $1,228,000.

Project 2: Purchase Patent for New Product

The patent would cost $4,065,000, which would be fully amortized over five years. Production of this product would generate $894,300 additional annual net income for Hearne.

Project 3: Purchase a New Fleet of Delivery Trucks

Hearne could purchase 25 new delivery trucks at a cost of $210,000 each. The fleet would have a useful life of 10 years, and each truck would have a salvage value of $6,900. Purchasing the fleet would allow Hearne to expand its customer territory resulting in $1,155,000 of additional net income per year.

1. Determine each project's accounting rate of return,and determine each project's payback period.

2(a) Using a discount rate of 10 percent, calculate the net present value of each project. (Future Value of $1, Present Value of $1, Future Value Annuity of $1, Present Value Annuity of $1.)

2(b)Determine the profitability index of each project and prioritize the projects for Hearne.

Answer 1

Below are the formulas used for calculating Accounting Rate of Return

Accounting Rate of Return =	Average Annual Accounting Profit
	Initial Investment

Annual Depreciation = (Initial Investment ? Salvage Value) ÷ Useful Life in Years

Average Annual Accounting Profit = Net Cash Flow – Annual Depreciation – Annual Amortization

Calculation of ARR for project 1:

Annual Depreciation = ($5,800,000 - $1,228,000)/8 = $571,500

Average Annual Accounting Profit = $1,036,000 - $571,500 = $464,500

Initial Investment = $5,800,000

ARR = 464500/5800000 = 8.009%

Calculation of ARR for project 2:

Annual Amortization = $4,065,000/5 = $813,000

Average Annual Accounting Profit = $894,300 - $813,000 = $81,300

Initial Investment = $4,065,000

ARR = 81300/4065000 = 2%

Calculation of ARR for project 3:

Annual Depreciation = ($5,250,000 - $172,500)/10 = $507,750

Average Annual Accounting Profit = $1,155,000 - $507,750 = $647,250

Initial Investment = $5,250,000

ARR = 647250/5250000 = 12.329%

NPV (Project 1) = -5800000 + 1036000 * PVIFA (10%, 8) + 1228000 * PVIF (10%,8)

= -5800000 + 1036000 * 5.334926 + 122800 * 0.466507

= $299854

NPV (Project 2) = -4065000 + 894300 * PVIFA (10%, 5)

= -4065000 + 894300 * 3.790787

= -$674899

NPV (Project 3) = -5250000 + 1155000 * PVIFA (10%,10) + 172500 * PVIF (10%, 10)

= -5250000 + 1155000 * 6.144567 + 172500 * 0.385543

= $1913481

Project Profitability Index = (NPV of project + Initial Investment) / Initial investment

Project Profitability Index (Project 1) = (299854 + 5800000) / 5800000 = 1.052

Project Profitability Index (Project 2) = (-674899 + 4065000) / 4065000 = 0.834

Project Profitability Index (Project 3) = (1913481 + 5250000) / 5250000 = 1.36

In terms of profitability index, below is the priority of projects:

1. Project 3
2. Project 1
3. Project 2 (loss making project in terms of NPV)