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 $5,300,000. It would generate $946,000 in additional net cash flow each year. The new machinery has a useful life of eight years and a salvage value of $1,108,000.

Project 2: Purchase Patent for New Product

The patent would cost $3,715,000, which would be fully amortized over five years. Production of this product would generate $631,550 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 $160,000 each. The fleet would have a useful life of 10 years, and each truck would have a salvage value of $5,900. Purchasing the fleet would allow Hearne to expand its customer territory resulting in $680,000 of additional net income per year.

Required:
1. Determine each project's accounting rate of return. (Round your answers to 2 decimal places.)

       

2. Determine each project's payback period. (Round your answers to 2 decimal places.)

       

3. 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.) (Use appropriate factor(s) from the tables provided. Round your intermediate calculations to 4 decimal places and final answers to 2 decimal places.)

       

4. Determine the profitability index of each project and prioritize the projects for Hearne. (Round your intermediate calculations to 2 decimal places. Round your final answers to 4 decimal places.)

    

Answer 1

1) Calculation of Accounting Rate of Return (ARR)

ARR= (Average Profit/ Average Investment)*100

	P1	P2	P3
Total cash flows	$        8,676,000	$        3,157,750	$        5,499,000
		(631550*5)
Divide by life of machine	8	5	10
Average cash flow	$        1,084,500	$            631,550	$            549,900
Less: Annual depreciation	$            524,000	$            743,000	$            385,250
	((5300000-1108000)/8)	(3715000/5)	((160000-5900)/10)*25
Average net profits	$            560,500	$         (111,450)	$            164,650
Investment	$        5,300,000	$        3,715,000	$        4,000,000
ARR	10.58%	-3.00%	4.12%

2) Calculation of Payback Period (PBP)

Project 1

Payback Period = Year immediately preceding the full recovery +(Unrecovered cost at beginning of the year in which full recovery is made/Cash flow in the year)

=5+((5300000-4730000)/946000)

=5.60 years

Project 2

Since cash flows are uniform, PBP = Initial investment/Annual outflow

=3715000/631550

=5.88 years

Project 3

Payback Period = Year immediately preceding the full recovery +(Unrecovered cost at beginning of the year in which full recovery is made/Cash flow in the year)

'=5+((4000000-3400000)/680000)

=5.88 years

3) Calculation of Net Present Value (NPV)

Project 1

Project 2

Project 3

4) Calculation of Profitability Index (PI)

In case of any questions on the above workings, please share the same in the comments section.

All the best!