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 operating income and net cash flows from each investment are as follows:

	Front-End Loader					Greenhouse
Year	Operating Income		Net Cash Flow			Operating Income		Net Cash Flow
1	$41,800		$136,000			$88,000		$218,000
2	41,800		136,000			67,000		184,000
3	41,800		136,000			33,000		129,000
4	41,800		136,000			15,000		88,000
5	41,800		136,000			6,000		61,000
Total	$209,000		$680,000			$209,000		$680,000

Each project requires an investment of $380,000. 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, round to the nearest dollar. 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 Rate of Return = Average Net Income/Average Investment

Average Investment = (Beginning Investment + Ending Investment)/2

= (380,000+0)/2

= $190,000

Average rate of return = Average Income/Average Investment

Front end Loader = 41800/190,000

=22%

Greenhouse = 41800/190,000

=22%

1b. NPV = Present value of cash inflows – Present value of cash outflows

	Front end Loader	Greenhouse
Present Value of net cash flow	3.79*136000 = $515,440	545,010
Amount to be invested	380,000	380,000
Net Present Value	135,440	165,010

Smaller NPV, Later in time

Greenhouse is more attractive