Question

Average Rate of Return Method, Net Present Value Method, and Analysis

The capital investment committee of Nature’s Portrait 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 Fixtures
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

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.

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
Greenhouse	%
Front End Loader	%

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

	Front End Loader	Greenhouse
Present value of net cash flow total	$	$
Less amount to be invested	$	$
Net present value	$	$

2. The front end loader has a net present value because cash flows occur earlier in time compared to the greenhouse fixtures. Thus, if only one of the two projects can be accepted, the would be the more attractive.

Answer 1

Average Rate of Return = Average Net Income/Average Investment

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

= (75,000+0)/2

= $37,500

Average rate of return = Average Income/Average Investment

Front end Loader = 11,250/37,500

=30%

Greenhouse = 11,250/37,500

=30%

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

	Front end Loader	Greenhouse
Present Value of net cash flow	99,940,75	26,250*3.605 = $94,631.25
Amount to be invested	75000	75000
Net Present Value	24,940.75	19,631.25

Higher NPV, Earlier in time

Front end loader is more attractive

Higher net present value of front end loader makes it a better investment