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:

	Front-End Loader					Greenhouse
Year	Income from Operations		Net Cash Flow			Income from Operations		Net Cash Flow
1	$59,400		$195,000			$125,000		$312,000
2	59,400		195,000			95,000		263,000
3	59,400		195,000			48,000		185,000
4	59,400		195,000			21,000		127,000
5	59,400		195,000			8,000		88,000
Total	$297,000		$975,000			$297,000		$975,000

Each project requires an investment of $540,000. 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, 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   net present value because the cash flows occur   in time compared to the greenhouse. Thus, if only one of the two projects can be accepted, the   would be the more attractive.

Answer 1

Average net income	59400	=297000/5
Average investment	270000	=540000/2
1a
	Average Rate of Return
Front-End Loader	22%	=59400/270000
Greenhouse	22%	=59400/270000
1b
	Front-End Loader	Greenhouse
Present value of net cash flow	739050	781170
Amount to be invested	540000	540000
Net present value	199050	241170
2
The front-end loader has a smaller net present value because the 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.
Workings:
	Front-End Loader			Greenhouse
	Cash flows	PV factor	Present value	Cash flows	PV factor	Present value
1	195000	0.909	177255	312000	0.909	283608
2	195000	0.826	161070	263000	0.826	217238
3	195000	0.751	146445	185000	0.751	138935
4	195000	0.683	133185	127000	0.683	86741
5	195000	0.621	121095	88000	0.621	54648
		Total	739050		Total	781170