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 | $42,000 | $137,000 | $88,000 | $219,000 | ||||||
2 | 42,000 | 137,000 | 67,000 | 185,000 | ||||||
3 | 42,000 | 137,000 | 34,000 | 130,000 | ||||||
4 | 42,000 | 137,000 | 15,000 | 89,000 | ||||||
5 | 42,000 | 137,000 | 6,000 | 62,000 | ||||||
Total | $210,000 | $685,000 | $210,000 | $685,000 |
Each project requires an investment of $420,000. Straight-line depreciation will be used, and no residual value is expected. The committee has selected a rate of 15% 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 earlier in time compared to the greenhouse. Thus, if only one of the two projects can be accepted, the greenhouse would be the more attractive.
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