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 income from operations and net cash flows from each investment are as follows:

	Front-End Loader					Greenhouse
Year	Income from Operations		Net Cash Flow			Income from Operations		Net Cash Flow
1	$42,000		$137,000			$88,000		$219,000
2	42,000		137,000			67,000		185,000
3	42,000		137,000			34,000		130,000
4	42,000		137,000			15,000		89,000
5	42,000		137,000			6,000		62,000
Total	$210,000		$685,000			$210,000		$685,000

Each project requires an investment of $420,000. Straight-line depreciation will be used, and no residual value is expected. The committee has selected a rate of 15% 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, 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 smaller net present value because cash flows occur earlier in time compared to the greenhouse. Thus, if only one of the two projects can be accepted, the greenhouse would be the more attractive.

Answer 1

1a
Average net income	42000	=210000/5
Average investment	210000	=420000/2
	Average Rate of Return
Front-End Loader	20%	=42000/210000
Greenhouse	20%	=42000/210000
b
	Front-End Loader	Greenhouse
Present value of net cash flow	459361	497652
Amount to be invested	420000	420000
Net present value	39361	77652
2
The front-end loader has a smaller net present value because cash flows occur earlier in time compared to the greenhouse. Thus, if only one of the two projects can be accepted, the greenhouse would be the more attractive.
Workings:
	Front-End Loader			Greenhouse
Year	Cash flows	PV factor	Present value	Cash flows	PV factor	Present value
1	137000	0.870	119190	219000	0.870	190530
2	137000	0.756	103572	185000	0.756	139860
3	137000	0.658	90146	130000	0.658	85540
4	137000	0.572	78364	89000	0.572	50908
5	137000	0.497	68089	62000	0.497	30814
		Total	459361		Total	497652