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	$57,000		$174,000			$120,000		$278,000
2	57,000		174,000			91,000		235,000
3	57,000		174,000			46,000		165,000
4	57,000		174,000			20,000		113,000
5	57,000		174,000			8,000		79,000
Total	$285,000		$870,000			$285,000		$870,000

Each project requires an investment of $600,000. Straight-line depreciation will be used, and no residual value is expected. The committee has selected a rate of 10% 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 later  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

Average net income	57000	=285000/5
Average Investment	300000	=600000/2
1a
	Average Rate of Return
Front-End Loader	19%	=57000/300000
Greenhouse	19%	=57000/300000
1b
	Front-End Loader	Greenhouse
Present value of net cash flow	659460	696965
Amount to be invested	600000	600000
Net present value	59460	96965
2
The front-end loader has a smaller net present value because cash flows occur later 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
	Cash flows	PV factor 10%	Present value	Cash flows	PV factor 10%	Present value
1	174000	0.909	158166	278000	0.909	252702
2	174000	0.826	143724	235000	0.826	194110
3	174000	0.751	130674	165000	0.751	123915
4	174000	0.683	118842	113000	0.683	77179
5	174000	0.621	108054	79000	0.621	49059
		Total	659460		Total	696965