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

Solution 1a:

Average rate or return = Average annual income / Average investment

Average investment = ($420,000 + 0) / 2 = $210,000

Average annual income - Front end loader = $210,000 / 5 = $42,000

Average annual income - Greenhouse = $210,000 / 5 = $42,000

Average rate of return - Front end loader = $42,000 / $210,000 = 20%

Average rate of return - Greenhouse = $42,000 / $210,000 = 20%

Solution 1b:

Computation of Present Value of cash Inflows
Particulars	Period	PV factor	Frontend loader		Greenhouse
			Amount	Present Value	Amount	Present Value
Cash inflows:
Year 1	1	0.870	$137,000.00	$119,190.00	$219,000.00	$190,530.00
Year 2	2	0.756	$137,000.00	$103,572.00	$185,000.00	$139,860.00
Year 3	3	0.658	$137,000.00	$90,146.00	$130,000.00	$85,540.00
Year 4	4	0.572	$137,000.00	$78,364.00	$89,000.00	$50,908.00
Year 5	5	0.497	$137,000.00	$68,089.00	$62,000.00	$30,814.00
Present value of cash inflows				$459,361.00		$497,652.00

Computation of NPV
Particualrs	Frontend loader	Greenhouse
Present value of cash inflows	$459,361.00	$497,652.00
Amount to be invested	$420,000.00	$420,000.00
Net Present value	$39,361.00	$77,652.00

Solution 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