Question

PA11-3 Comparing, Prioritizing Multiple Projects [LO 11-1, 11-2, 11-3, 11-6]

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 $4,900,000. It would generate $874,000 in additional net cash flow each year. The new machinery has a useful life of eight years and a salvage value of $1,012,000.

Project 2: Purchase Patent for New Product

The patent would cost $3,435,000, which would be fully amortized over five years. Production of this product would generate $446,550 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 $120,000 each. The fleet would have a useful life of 10 years, and each truck would have a salvage value of $5,100. Purchasing the fleet would allow Hearne to expand its customer territory resulting in $360,000 of additional net income per year.

Answer 1

1. Accounting rate of return = Annual accounting income / Initial investment x 100:
	Accounting rate of return
Project 1	7.92%
Project 2	13%
Project 3	12%
2. Payback period = Initial investment / Average annual cash flows:
	Payback period
Project 1	5.61 years
Project 2	3.03 years
Project 3	4.63 years
3. Net Present value = Present value of cash inflows - Initial investment:
	NPV
Project 1	$ 234,801
Project 2	$ 862,061
Project 3	$ 1,026,244
4. Profitability index = Present value of cash inflows / Initial investment:
	PI
Project 1	0.9521 = 3
Project 2	1.2510 = 2
Project 3	1.3421 = 1