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 $5,150,000. It would generate $919,000 in additional net cash flow each year. The new machinery has a useful life of eight years and a salvage value of $1,072,000.

Project 2: Purchase Patent for New Product

The patent would cost $3,610,000, which would be fully amortized over five years. Production of this product would generate $559,550 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 $145,000 each. The fleet would have a useful life of 10 years, and each truck would have a salvage value of $5,600. Purchasing the fleet would allow Hearne to expand its customer territory resulting in $561,900 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.	ACCOUNTING RATE OF RETURN = AVERAGE NET PROFIT/AVERAGE INVESTMENT
DEPRECIATION =(INITIAL INVESTMENT- SCARP VALUE)/ NO OF YEARS
	PROJECT 1	PROJECT 2	PROJECT 3
INVESTMENT	51,50,000.00	36,10,000.00	36,25,000.00
SCRAP VALUE	10,72,000.00	-	1,40,000.00
NO. OF YEARS	8.00	5.00	10.00
DEPRECIATION	5,09,750.00	7,22,000.00	3,48,500.00
AVERAGE NET PROFIT = NET INCOME-DEPRECIATION
	PROJECT 1	PROJECT 2	PROJECT 3
NET INCOME	9,19,000.00	5,59,550.00	5,61,900.00
DEPRECIATION	5,09,750.00	7,22,000.00	3,48,500.00
AVERAGE NET PROFIT	4,09,250.00	-1,62,450.00	2,13,400.00
ACCOUNTING RATE OF RETURN
	PROJECT 1	PROJECT 2	PROJECT 3
AVERAGE NET PROFIT	4,09,250.00	-1,62,450.00	2,13,400.00
INVESTMENT	51,50,000.00	36,10,000.00	36,25,000.00
ACCOUNTING RATE OF RETURN	7.95%	-4.50%	5.89%
2	PAYBACK PERIOD= INITIAL INVESTMENT/ ANNUAL CASH FLOW
	PROJECT 1	PROJECT 2	PROJECT 3
INVESTMENT	51,50,000.00	36,10,000.00	36,25,000.00
ANNUAL CASH FLOW	9,19,000.00	5,59,550.00	5,61,900.00
PAYBACK PERIOD	5.60	6.45	6.45	YEARS
3	NET PRESENT VALUE = PV OF CASH INFLOWS- PV OF CASH OUTFLOW
	PROJECT 1	PROJECT 2	PROJECT 3
ANNUAL CASH INFLOWS BEFORE DEPRECIATION	9,19,000.00	5,59,550.00	5,61,900.00
ADD:DEPRECIATION	5,09,750.00	7,22,000.00	3,48,500.00
ANNUAL CASH INFLOWS BEFORE DEPRECIATION (A)	14,28,750.00	12,81,550.00	9,10,400.00
PV FACTOR @10%(B)
FOR 8 YEARS	5.34	-	-
FOR 5 YEARS	-	3.79	-
FOR 10 YEARS	-	-	6.15
DISCOUNTED CASH FLOW (A*B=C)	76,22,381.25	48,58,356.05	55,94,408.00
ADD: PV OF SCRAP VALUE(D)
(SCRAP VALUE* PV FACTOR)
1072000*0.4655	4,99,016.00	-	-
140000*0.3855	-	-	53,970.00
TOTAL OF CASH INFLOWS(C+D=E)	81,21,397.25	48,58,356.05	56,48,378.00
LESS: CASH OUTFLOW	51,50,000.00	36,10,000.00	36,25,000.00
NPV	29,71,397.25	12,48,356.05	20,23,378.00
4	PROFITABILITY INDEX =1+(NPV/INITIAL INVESTMENT)
	PROJECT 1	PROJECT 2	PROJECT 3
NPV	29,71,397.25	12,48,356.05	20,23,378.00
INITIAL INVESTMENT	51,50,000.00	36,10,000.00	36,25,000.00
NPV/ INITIAL INVESTMENT(A)	0.58	0.35	0.56
1+A	1.58	1.35	1.56