Question

Hearne Company has a number of potential capital investments. Because these projects vary in nature, initial investment, and time horizon, management is finding it difficult to compare them. Assume straight line depreciation method is used.   

Project 1: Retooling Manufacturing Facility

This project would require an initial investment of $5,500,000. It would generate $982,000 in additional net cash flow each year. The new machinery has a useful life of eight years and a salvage value of $1,156,000.

Project 2: Purchase Patent for New Product

The patent would cost $3,855,000, which would be fully amortized over five years. Production of this product would generate $732,450 additional annual net income for Hearne.

Project 3: Purchase a New Fleet of Delivery Trucks

Hearne could purchase 25 new delivery trucks at a cost of $180,000 each. The fleet would have a useful life of 10 years, and each truck would have a salvage value of $6,300. Purchasing the fleet would allow Hearne to expand its customer territory resulting in $855,000 of additional net income per year.

Heame Company has a number of potential capital investments. Because these projects vary in nature, initial investment, and time horizon, management is finding it difficult to compare them. Assume straight line depreciation method is used. Project 1: Retooling Manufacturing Facility This project would require an initial investment of $5,500,000. It would generate $982,000 in additional net cash flow each year. The new machinery has a useful life of eight years and a salvage value of $1,156,000. Project 2: Purchase Patent for New Product The patent would cost $3,855,000, which would be fully amortized over five years. Production of this product would generate $732,450 additional annual net income for Hearne. Project 3: Purchase a New Fleet of Delivery Trucks Heame could purchase 25 new delivery trucks at a cost of $180,000 each. The fleet would have a useful life of 10 years, and each truck would have a salvage value of $6,300. Purchasing the fleet would allow Hearne to expand its customer territory resulting in $855,000 of additional net income per year. Required: 1. Determine each project's accounting rate of return. (Round your answers to 2 decimal places.) Accounting Rate of Return Project 1 Project 2 Project 3 2. Determine each project's payback period. (Round your answers to 2 decimal places.) Payback Period Proiect 1 Years Years Project 2 Project 3 Years

Answer 1

Project	Accounting rate of return
Project 1	7.98%
Project 2	-1%
Project 3	9.35%

Working Notes:

ARR for project 1 = (Net profit (cash flows) - Depreciation) / cost of the asset

= ($982,000- $543,000) / $5,500,000

= 7.98 %

ARR for project 2 = ($732,450 - $771,000) / $3,855,000

= - 1%

ARR for project 3 = ( $855,000 - $434,250) / $4,500,000

= 9.35%

Required 2:

Project	Payback period
Project 1	5.6 years
Project 2	5.26 years
Project 3	5.26 years

Payback period = Initial investment / Annual payback

• Project 1 = $5,500.000 / $ 982,000 = 5.6 years
• Project 2 = $3,855,000 / $732,450 = 5.26 years
• Project 3 = $4,500,000 / $855,000 = 5.26 years

Required 3:

Project	Net present value
Project 1	- $ 261,102.47
Project 2	- $ 1,078,438.23
Project 3	$ 753,604.88

Required 4:

Project	Profitability index	Rank
Project 1	0.9525	2
Project 2	0.7202	3
Project 3	1.1675	1

Profitability index = NPV of Cash inflows / NPV of Investment

• Project 1 = $5,238,897.53 / $5,500,000 = 0.9525
• Project 2 = $2,776,561.77 / $3,855,000 = 0.7202
• Project 3 = $5,253,604.88 / $4,500,000 = 1.1675