Average Rate of Return Method, Net Present Value Method, and Analysis
The capital investment committee of Ellis Transport and Storage Inc. is considering two investment projects. The estimated income from operations and net cash flows from each investment are as follows:
Warehouse | Tracking Technology | |||||||||
Year | Income from Operations |
Net Cash Flow |
Income from Operations |
Net Cash Flow |
||||||
1 | $52,200 | $161,000 | $110,000 | $258,000 | ||||||
2 | 52,200 | 161,000 | 84,000 | 217,000 | ||||||
3 | 52,200 | 161,000 | 42,000 | 153,000 | ||||||
4 | 52,200 | 161,000 | 18,000 | 105,000 | ||||||
5 | 52,200 | 161,000 | 7,000 | 72,000 | ||||||
Total | $261,000 | $805,000 | $261,000 | $805,000 |
Each project requires an investment of $580,000. 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 | |
Warehouse | % |
Tracking Technology | % |
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.
Warehouse | Tracking Technology | |
Present value of net cash flow total | $ | $ |
Less amount to be invested | $ | $ |
Net present value | $ | $ |
2. The warehouse has a net present value as tracking technology cash flows occur in time. Thus, if only one of the two projects can be accepted, the would be the more attractive.
Solution 1a:
Average rate of return = Average annual income / Average investment
Average annual income:
Warehouse = $261,000 / 5 = $52,200
Tracking technology = $261,000 / 5 = $52,200
Average investment:
Warehouse = ($580,000 + 0) / 2 = $290,000
Tracking technology = ($580,000 + 0) / 2 = $290,000
Average rate of return:
Warehouse = $52,200 / $290,000 = 18%
Tracking technology = $52,200 / $290,000 = 18%
Solution 1b:
Computation of NPV | ||||||
Warehouse | Tracking Technology | |||||
Particulars | Period | PV Factor | Amount | Present Value | Amount | Present Value |
Cash outflows: | ||||||
Cost of Equipment | 0 | 1 | $580,000 | $580,000 | $580,000 | $580,000 |
Present Value of Cash outflows (A) | $580,000 | $580,000 | ||||
Cash Inflows | ||||||
Year 1 | 1 | 0.909 | $161,000 | $146,349 | $258,000 | $234,522 |
Year 2 | 2 | 0.826 | $161,000 | $132,986 | $217,000 | $179,242 |
Year 3 | 3 | 0.751 | $161,000 | $120,911 | $153,000 | $114,903 |
Year 4 | 4 | 0.683 | $161,000 | $109,963 | $105,000 | $71,715 |
Year 5 | 5 | 0.621 | $161,000 | $99,981 | $72,000 | $44,712 |
Present Value of Cash Inflows (B) | $610,190 | $645,094 | ||||
Net Present Value (NPV) (B-A) | $30,190 | $65,094 |
Solution 2:
The Warehouse has a lower net present value as tracking technology cash flow occur earlier in time. Thus, if only one of the two projects can be accepted, the tracking technology would be the more attractive.
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