Question

PA11-3 Comparing, Prioritizing Multiple Projects [LO 11-1, 11-2, 11-3, 11-6]

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 $4,950,000. It would generate $883,000 in additional net cash flow each year. The new machinery has a useful life of eight years and a salvage value of $1,024,000.

Project 2: Purchase Patent for New Product

The patent would cost $3,470,000, which would be fully amortized over five years. Production of this product would generate $468,450 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 $125,000 each. The fleet would have a useful life of 10 years, and each truck would have a salvage value of $5,200. Purchasing the fleet would allow Hearne to expand its customer territory resulting in $421,900 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

Answer 1
Accounting rate of return = Average annual accounting profit / Initial investment in project
	Project 1	Project 2	Project 3
Average annual accounting profit	$392,250.00	$468,450.00	$421,900.00
/ Initial Investment in project	$4,950,000.00	$3,470,000.00	$3,125,000.00
Accounting rate of return	7.92%	13.50%	13.50%
Project 1 depreciation per year using straight line method = (cost - residual value)/useful life = ($4950000 - $1024000)/8 years = $4,90,750
Annual accounting profit of Project 1 = additional net cah flow - Depreciation = $883000 - $490750 = $3,92,250
Answer 2
Determination of each project's payback period
	Project 1	Project 2	Project 3
Initial Investment in project	$4,950,000.00	$3,470,000.00	$3,125,000.00
/ Additional annual net cash inflow	$883,000.00	$1,162,450.00	$721,400.00
Payback period (in years)	5.61	2.99	4.33
Patent amortization per year = Initial investment / useful life = $34,70,000 / 5 years = $6,94,000
Additional annual net cash inflow in case of Project 2 = Additional annual net income + Patent amortization = $468450 + $694000 = $11,62,450
Project 3 depreciation per year using straight line method = (cost - residual value)/useful life = ($3125000 - $130000)/10 years = $2,99,500
Additional annual net cash inflow in case of Project 3 = Additional annual net income + Depreciation = $421900 + $299500 = $7,21,400
Answer 3
Present value of annuity = P * {[1 - (1+r)^-n]/r}
Present value of annuity of $1 at 10% for 8 years = 1 * {[1 - (1+0.10)^-8]/0.10} = 5.334926
Present value of annuity of $1 at 10% for 5 years = 1 * {[1 - (1+0.10)^-5]/0.10} = 3.790787
Present value of annuity of $1 at 10% for 10 years = 1 * {[1 - (1+0.10)^-10]/0.10} = 6.144567
Calculation of NPV of each project
	Project 1	Project 2	Project 3
Present value factor	5.334926	3.790787	6.144567
x Additional annual net cash inflow	$883,000.00	$1,162,450.00	$721,400.00
Present value of cash inflows	$4,710,739.66	$4,406,600.35	$4,432,690.63
Less : Initial Investment	$4,950,000.00	$3,470,000.00	$3,125,000.00
NPV	-$239,260.34	$936,600.35	$1,307,690.63
Answer 4
Determination of profitability index of each project
	Project 1	Project 2	Project 3
Present value of future cash flows	$4,710,739.66	$4,406,600.35	$4,432,690.63
/ Initial Investment	$4,950,000.00	$3,470,000.00	$3,125,000.00
Profitability Index	0.9517	1.2699	1.4185