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 $5,100,000. It would generate $910,000 in additional net cash flow each year. The new machinery has a useful life of eight years and a salvage value of $1,060,000.

Project 2: Purchase Patent for New Product

The patent would cost $3,575,000, which would be fully amortized over five years. Production of this product would generate $536,250 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 $140,000 each. The fleet would have a useful life of 10 years, and each truck would have a salvage value of $5,500. Purchasing the fleet would allow Hearne to expand its customer territory resulting in $525,000 of additional net income per year.

Calculate each projects accounting rate of return and payback period.

Using a discount rate of 10 percent, calculate the net present value of each project, and Determine the profitability index of each project and prioritize the projects for Hearne.

Answer 1

Computation of Accounting Rate of Return:

Computation of Accounting Rate of Return Accounting Rate of Return Net Operating Income/Average Investment Average Investment (Book Value of Investment in beginning Book Value of investment at the end)/2 Project 1 Project2 Project 3 Annual Operating Income Initial Investment $ Calculation Salvage Value Calculation 9,10,000 $ 51,00,000$ 5,36,250 $ 35,75,000 $ 5,25,000 35,00,000 (25*140000) 10,60,000 $ 1,37,500 (25*5500) Life 8 10 7,15,000$ 5,05,000 $ Depreciation 3,36,250 (51,00,000 10,60,000)/8 (35,75,000)/5 (35,00,000 137,500)/10 Calculation Net Annual Operating Income $ (1,78,750)$ 4,05,000 $ 1,88,750 Calculation Average Investment (910,000 505,000) (536,250 715,000) (525,000 336,250) 35,75,000 $ 30,80,000$ 18,18,750 (51,00,000 10,60,000)/2 (35,00,000137,500)/2 Calculation Accounting Rate of Return 13.15% -5.00% 10.38% (405,000/30,80,000) 178,750/35,75,000)*1 100 (188,750/18,18,750)*100 Calculation

Computation of Payback Period of the Projects:

Computation of Payback Period Pay back period is computed using this formula: (when annual cash flows are same through the useful life) Pay back period Investment/Annual Cashflows Project 1 Project 2 Project 35,75,000$ 51,00,000 $ Investment Annual net cash flows $ Pay back period Calculation Note: Depreciation is a non cash expense and will not affect our cash flows, 35,00,000 5,25,000 6.67 (51,00,000/910000) (35,75,000/536250 (35,00,000/525000) 9,10,000 $5,36,250 $ 6.67 $ 5.60 $ hence it has not been considered.

Computation of NPV for Project 1:

Computation of NPV Project 1 Computation of Present Value on Cash Inflows Present value of cash inflows = (Annual Net Cash flow X Present Value of Annuity of $ 1 @ 10 % for 8 years) + (Salvage valueX Present value of $ 1 @ 10% for the 8th year) Present value of cash inflows(S 910,000*5.334926)($ 10,60,000 0.466507) Present value of cash inflows$53,49,280 Workings: Annual Net Cashflows $ 910,000 Discount rate-cost of capital-10% Present Value of Annity (PVOA of Discount Factor of 10%) for 8 years-5.334926 Present Value of $ 1 @ 10% for the 8th year-0.466507 Computation of Net Present Value Net present value Present value of cash inflows - Investment Net present value 53,49,280 51,00,000 Net present value 249,280

Computation of NPV for Project 2:

Project 2 Present value of cash inflows- (Annual Net Cash flow.x Present Value of Annuity of $ 1 @ 10 % for 5 years) Present value of cash inflows536,250*3.790787) Present value of cash inflows$20,32,810 Net present value Present value of cash inflows Investment Net present value 20,32,810 35,75,000 Net present value - 15,42,190 Workings: Annual Net Cashflows $ 536,250 Present Value of Annity (PVOA of Discount Factor of 10%) for 5 years-3.790787

Computation of NPV for Project 3:

Project 3 Computation of Present Value on Cash Inflows Present value of cash inflows- (Annual Net Cash flow X Present Value of Annuity of $ 1 @ 10 % for 10 years) + (Salvage valueX Present value of $ 1 @ 10% for the 10th year) Present value of cash inflows$525,000*6.144567) ($ 137,500 0.385543) Present value of cash inflows 32,78,910 Workings: Annual Net Cashflows $ 525,000 Discount rate-cost of capital-10% Present Value of Annity (PVOA of Discount Factor of 10%) for 10 years 6.144567 Present Value of $ 1 @ 10% for the 10th year-0.385543 Computation of Net Present Value Net present value Present value of cash inflows Investment Net present value $ 32,78,910 35,00,000 Net present value $-221,090

Profitability Index of the Projects and Conclusion:

Computation of Project Profitability Index Formula for Project Profitability Index Present value of Future cash flows/Intial investment Project 3 Project 1 Project2 Present Value of Cash Flows 53,49,280 $ 20,32,810 $ 32,78,910 Initial Investment $ Profitability Index Calculation 51,00,000 $ 35,75,000 $ 35,00,000 1.05 0.57 0.94 (53,49,280/51,00,000) (20,32,810/35,75,000) (32,78,910/35,00,000) Conclusion Project 1 gives the highest accounting rate of return as compared to both the projects The payback period of Project 1 is also much better as compared to Project 2 and 3 It indicates we will be able to recover our investment much faster than Project 2 and 3 Project 1 has a positive NPV, hence it should be accepted. Project 2 and 3 should not be accepted as they have negative NPV