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 $5,550,000. It would generate $991,000 in additional net cash flow each year. The new machinery has a useful life of eight years and a salvage value of $1,168,000.

Project 2: Purchase Patent for New Product

The patent would cost $3,890,000, which would be fully amortized over five years. Production of this product would generate $758,550 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 $185,000 each. The fleet would have a useful life of 10 years, and each truck would have a salvage value of $6,400. Purchasing the fleet would allow Hearne to expand its customer territory resulting in $901,900 of additional net income per year.


Required:
1. Determine each project's accounting rate of return. (Round your answers to 2 decimal places.)
Project 1: %

Project 2: %

Project 3: %
       

2. Determine each project's payback period. (Round your answers to 2 decimal places.)

Project 1: Years

Project 2: Years

Project 3: Years
       

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.)
Project 1:

Project 2:

Project 3:
       

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.)

Project 1: Rank:

Project 2: Rank:

Project 3: Rank:

Answer 1

Solution:

Project 1: Accounting Rate of Return:

Net cash flow per year=991000

Depreciation=(5550000-1168000)/8=547750

Average Annual Return=991000-547750=443250

Accounting Rate of Return=Average Annual Return/Average Investment

=443250/(1/2*(5550000+1168000)) *100=(443250/3359000)*100

=13.19%

Payback period=5550000/991000=5.60 years

NPV:

PV of annual cash flows=991000*PVIFA(10,8)=991000*5.3349=5286885.9

PV of salvage Value=1168000*PVIF(10,8)=1168000*0.4665=544872

Total PV of cash inflows=5286886+544872=5831758

Intial investment 5550000

NPV=5831758-5550000=281758

Profitability index=PV of cash inflows/intial investment=5831758/5550000=1.05

Project 2:

   Accounting Rate of Return=Average Annual Return/Average Investment

=758550/1945000*100=39%

Payback period=3890000/(758550+Amorization 778000)

=3890000/1536550=2.53Years

NPV: Annual cash flows=758550+778000=1536550

PV of annual cash flows=1536550*PVIFA(10,5)=1536550*3.7908=5824754

Intial investment 3890000

NPV=5824754-3890000=1934754

    Profitability index=PV of cash inflows/intial investment=5824754/3890000=1.50

Project 3:

Average annual income=901900

Average Investment=10*(185000+6400)/2=957000

Accounting Rate of Return=901900/957000*10=94.24%

Pay back period:

Annual cashflow=901900+10*(185000-6400)/10=1080500

Pay back period=185000*10/1080500=1.71 years

NPV: PV of annual cash flows=1080500*PVIFA(10,10)=1080500*6.1446=6639240

PV of residual value=6400*10/1.10^10=6400*3.8554=24675

Total of PV of cash inflows=6639240+24675=6663915

Intial investment=185000*10=1850000

NPV=6663915-1850000=4813915

Profitability Index=6663915/1850000=3.60

Note: For project 1 annual cash flows are given and hence to arrive at annual net income depreciation has been deducted from it.For Projects 2&3, annual net income is given and hence depreciation has been added to get annual cash flows.

Project	ARR	PB	NPV	PI
1	13.19%	5.6 years	281758	1.05
2	39%	2.53 years	1934754	1.50
3	95.24%	1.71 years	1850000	3.6

Project 3 has Rank 1 Under ARR,PB and PI

Project 2 has Rank 1 Under NPV

Project 1 has Rank 3 under all evaluation methods.