Average Rate of Return Method, Net Present Value Method, and Analysis for a Serv

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:

Each project requires an investment of $75,000. Straight-line depreciation will be used, and no residual value is expected. The committee has selected a rate of 12% for purposes of the net present value analysis.

Required:

1a. Compute the average rate of return for each investment. If required, round your answer to one decimal place.

1b. Compute the net present value for each investment. Use the present value of $1 table above. If required, round to the nearest dollar.

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 net present value because cash flows occur earlier in time compared to the greenhouse. Thus, if only one of the two projects can be accepted, the would be the more attractive.

Front-End Loader Greenhouse Year Income from Operations Net Cash Flow Income from Operations Net Cash Flow 1 $25,000 $ 40,000 $11,250 $ 26,250 2   20,000    35,000   11,250    26,250 3   7,000    22,000   11,250    26,250 4   3,000    18,000   11,250    26,250 5   1,250    16,250   11,250    26,250 $56,250 $131,250 $56,250 $131,250

Explanation / Answer

Front-End Loader Greenhouse Year Income from Operations Net Cash Flow Income from Operations Net Cash Flow 1 $25,000 $40,000 $11,250 $26,250 2 20000    35,000 $11,250    26,250 3 7000    22,000 $11,250    26,250 4 3000    18,000 $11,250    26,250 5 1250    16,250 $11,250    26,250 Total $56,250 $131,250 $56,250 $131,250 No of years 5 5 Average Rate Total/5 11250 $11,250 Average Rate of Return Average Profit/Average investment 11250/((75000+0)/2)*100 30 % Average Rate of Return Greenhouse 30% Front-End Loader 30% Front-End Loader Greenhouse Present value of net cash flow $99,941 $94,631 Amount to be invested 75000 75000 Net present value $24,941 $19,631 working Front-End Loader Year Net Cash Flow Discount factor 12% Discounted cash flow 1 $40,000 0.893 $35,720 2 35000 0.797 $27,895 3 22000 0.712 $15,664 4 18000 0.636 $11,448 5 16250 0.567 $9,214 $131,250 $99,941 Greenhouse Year Net Cash Flow Discount factor 12% Discounted cash flow 1 $26,250 0.893 $23,441 2 $26,250 0.797 $20,921 3 $26,250 0.712 $18,690 4 $26,250 0.636 $16,695 5 $26,250 0.567 $14,884 $131,250 $94,631 Ans 2 Front end loader has more NPV because cash flow occur earlier. Thus if one of the project is accepted than Front end loader is better than Freenhouse

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