Question

Average Rate of Return Method, Net Present Value Method, and Analysis

The capital investment committee of Ellis Transport and Storage Inc. is considering two investment projects. The estimated income from operations and net cash flows from each investment are as follows:

	Warehouse					Tracking Technology
Year	Income from Operations		Net Cash Flow			Income from Operations		Net Cash Flow
1	$43,200		$133,000			$91,000		$213,000
2	43,200		133,000			69,000		180,000
3	43,200		133,000			35,000		126,000
4	43,200		133,000			15,000		86,000
5	43,200		133,000			6,000		60,000
Total	$216,000		$665,000			$216,000		$665,000

Each project requires an investment of $480,000. 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
Warehouse	%
Tracking Technology	%

1b. Compute the net present value for each investment. Use the present value of $1 table above. If required, use the minus sign to indicate a negative net present value.

	Warehouse	Tracking Technology
Present value of net cash flow total	$	$
Less amount to be invested	$	$
Net present value	$	$

2. The warehouse has a   net present value as tracking technology cash flows occur   in time. Thus, if only one of the two projects can be accepted, the   would be the more attractive.

Answer 1

1a. Average rate of return = Average annual net earnings after taxes / Initial investment *100%

Warehouse: Average annual net earnings = $216,000/5 = $43,200

Initial investment = $480,000

Therefore, Average rate of return = 43,200/480,000*100 = 9%

Tracking Technology: Average annual net earnings = $216,000/5 = $43,200

Initial investment = $480,000

Therefore, Average rate of return = 43,200/480,000*100 = 9%

1b. Warehouse: Since the cash flow of each year is $133,000

Therefore, present value of cash flow = $133,000 * total discounting factors for 5 years @10%

= $133,000 * (0.909+0.826+0.751+0.683+0.621) = $133,000*3.79 = $504,070

Amount to be invested = $480,000

Therefore, Net Present Value = $504,070 - $480,000 = $24,070

Tracking Technology: Present value of cash flow = Each year net cash flow * discounting factor @10% of each year for 5 years

Therefore, present value of cash flow = $213,000*0.909 + $180,000*0.826 + $126,000*0.751 + $86,000*0.683 + $60,000*0.621 = $532,921

  Amount to be invested = $480,000

  Therefore, Net Present Value = $532,921 - $480,000 = $52,921

2. If only one of the two projects can be accepted, then the investment in Warehouse would be more attractive as its NPV is better compared to the Tracking Technology at the same annual rate of return.