Hearne Company has a number of potential capital investments. Because these proj
ID: 2455025 • Letter: H
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.)
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.)
Explanation / Answer
1. Determine each project's accounting rate of return. (Round your answers to 2 decimal places.)
Project 1
Annual Depreciation = (Initial Investment-Salvage Value)/useful life
Annual Depreciation = (5550000-1168000)/8
Annual Depreciation = 547750
Accounting rate of return = Average Net Income/Average Investment
Average Net Income = net cash flow -Annual Depreciation
Average Net Income = 991000-547750
Average Net Income = 443250
Average Investment = (Initial Investment+Salvage Value)/2
Average Investment = (5550000+1168000)/2
Average Investment = 3359000
Accounting rate of return = 443250/3359000
Accounting rate of return = 13.20%
Project 2
Annual Amortisation Expenses = cost/useful life
Annual Amortisation Expenses =3890000/5
Annual Amortisation Expenses = 778000
Accounting rate of return = Average Net Income/Average Investment
Average Net Income = 758550
Average Investment = (Initial Investment+Salvage Value)/2
Average Investment = (3890000+0)/2
Average Investment = 1945000
Accounting rate of return = 758550/1945000
Accounting rate of return = 39%
Project 3
Annual Depreciation = (Initial Investment-Salvage Value)/useful life
Annual Depreciation = (185000-6400)*25/10
Annual Depreciation = 446500
Accounting rate of return = Average Net Income/Average Investment
Average Net Income = 901900
Average Investment = (Initial Investment+Salvage Value)/2
Average Investment = (185000*25+6400*25)/2
Average Investment = 2392500
Accounting rate of return = 901900/2392500
Accounting rate of return = 37.70%
2. Determine each project's payback period. (Round your answers to 2 decimal places.)
Project 1
Project's payback period = Initial Investment/Annual cash Flow
Project's payback period = 5550000/991000
Project's payback period = 5.60 Years
Project 2
Annual Amortisation Expenses = cost/useful life
Annual Amortisation Expenses =3890000/5
Annual Amortisation Expenses = 778000
Project's payback period = Initial Investment/Annual cash Flow
Average Net Income = 758550
Annual cash Flow = Average Net Income + Annual Amortisation Expenses
Annual cash Flow = 758550+778000
Annual cash Flow = $ 1536550
Project's payback period = 3890000/1536550
Project's payback period = 2.53 Years
Project 3
Annual Depreciation = (Initial Investment-Salvage Value)/useful life
Annual Depreciation = (185000-6400)*25/10
Annual Depreciation = 446500
Project's payback period = Initial Investment/Annual cash Flow
Average Net Income = 901900
Annual cash Flow = Average Net Income + Annual Amortisation Expenses
Annual cash Flow = 901900+446500
Annual cash Flow = $ 1348400
Initial Investment = 185000*25
Initial Investment = 4625000
Project's payback period = 4625000/1348400
Project's payback period = 3.43 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
NPV = -Initial Investment + Annual Cash flow *PVA(rate,nper)+ salvage value*PV(rate,nper)
NPV = - 5550000 + 991000*PVA(10%,8) + 1168000*PV(10%,8)
NPV = - 5550000 + 991000*5.3349+ 1168000*0.4665
NPV = 281,757.90
Project 2
NPV = -Initial Investment + Annual Cash flow *PVA(rate,nper)
NPV = - 3890000 + 991000*PVA(10%,5)
NPV = - 3890000 + 1536550*3.7908
NPV = 1934753.74
Project 3
NPV = -Initial Investment + Annual Cash flow *PVA(rate,nper)+ salvage value*PV(rate,nper)
NPV = - 4625000 + 1348400*PVA(10%,10) + 6400*25*PV(10%,10)
NPV = - 4625000 + 1348400*6.1446+ 6400*25*0.3855
NPV = 3722058.64
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
Profitability index = 1+ NPV/Initial Investment
Profitability index = 1+ 281757.90/5550000
Profitability index = 1.0508
Project 2
Profitability index = 1+ NPV/Initial Investment
Profitability index = 1+ 1934753.74/3890000
Profitability index = 1.4974
Project 3
Profitability index = 1+ NPV/Initial Investment
Profitability index = 1+ 3722058.64/4625000
Profitability index = 1.8047
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