Question

*Only project on is correct. Show me steps

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 $5,000,000. It would generate $892,000 in additional net cash flow each year. The new machinery has a useful life of eight years and a salvage value of $1,036,000. Project 2: Purchase Patent for New Product The patent would cost $3,505,000, which would be fully amortized over five years. Production of this product would generate $490,700 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 $130,000 each. The fleet would have a useful life of 10 years, and each truck would have a salvage value of $5,300. Purchasing the fleet would allow Hearne to expand its customer territory resulting in $455,000 of additional net income per year.

Required:

1. Determine each project's accounting rate of return.

	Accounting Rate of Return Project 1 7.93 % Project 2 (6.00) % Project 3 4.41 %

2.	Determine each project's payback period

Payback Period

Project 1 5.61 Years

Project 2 7.14 Years

Project 3 7.14 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.) Net Present Value Project 1 $242,055.83 Project 2 $(1,644,860.93) Project 3 $2,795,778.04 4. Determine the profitability index of each project and prioritize the projects for Hearne. Profitability Index /Rank Project 1 ? 3 Project 2 ? 2 Project 3 ? 1

Answer 1

Determining ARR ( Accounting rate of return )

ARR = Net Income / Investment * 100

Here Net Income = Annual cash flow - Depreciation   and   Depreciation = (Cost - Salvage) / Life

	Project - 1	Project - 2	Project - 3
Annual cash flow	892000
(-) Depreciation	495500
Net Income	396500	490700	455000
Investment	5000000	3505000	3250000
ARR =	7.93	14	14

CALCULATION OF PAYBACK PERIOD

Pay back period = Investment / Annual cash in flow.

Project - 1 we are already given with annual cash inflow. But for project - 2 and 3 we calculate it as Net Income + Depreciation

Investment	5000000	3505000	3250000
Annual cash inflow	892000	1191700	766750
Pay back	5.61	2.94	4.24

Year	DF	Pro - 1	Pro - 2	Pro - 3	PV(P-1)	PV(P-2)	PV(P-3)
0	1	-5000000	-3505000	-3250000	-5000000	-3505000	-3250000
1	0.9090909	892000	1191700	766750	810909.1	1083364	697045.5
2	0.8264463	892000	1191700	766750	737190.1	984876	633677.7
3	0.7513148	892000	1191700	766750	670172.8	895341.8	576070.6
4	0.6830135	892000	1191700	766750	609248	813947.1	523700.6
5	0.6209213	892000	1191700	766750	553861.8	739951.9	476091.4
6	0.5644739	892000		766750	503510.7	0	432810.4
7	0.5131581	892000		766750	457737	0	393464
8	0.4665074	1928000		766750	899426.2	0	357694.5
9	0.4240976	0		766750	0	0	325176.8
10	0.3855433	0		899250	0	0	346699.8
				NPV	242055.8	1012481	1512431

CALCULATION OF PROFITABILITY INDEX

Profitability Index = 1 + NPV/Investment

PI	Rank
1.05	3
1.29	2
1.47	1