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	$39,100		$122,000			$82,000		$195,000
2	39,100		122,000			63,000		165,000
3	39,100		122,000			31,000		116,000
4	39,100		122,000			14,000		79,000
5	39,100		122,000			5,500		55,000
Total	$195,500		$610,000			$195,500		$610,000

Each project requires an investment of $460,000. 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 smaller  net present value because 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.

Answer 1

Question 1A :

Front End Loader
Calculation of Average Rate of Return
Year	Income from Operations
1	$    39,100.00
2	$    39,100.00
3	$    39,100.00
4	$    39,100.00
5	$    39,100.00
Total for 5 Years	$ 1,95,500.00
Average Profits	=$195500/5
	$    39,100.00
ARR = Average Profits/ Average Investment = $39100/$460000=8.5%
Green House
Calculation of Average Rate of Return
Year	Income from Operations
1	$    82,000.00
2	$    63,000.00
3	$    31,000.00
4	$    14,000.00
5	$      5,500.00
Total for 5 Years	$ 1,95,500.00
Average Profits	=$195500/5
	$    39,100.00
ARR = Average Profits/ Average Investment = $39100/$460000=8.5%

It can be noticed that ARRis same in both the cases because it haven't considered Time Value of Money. Now, Analyze these cases with NPV Technique.

Question 1B:

Calculation of PV of Cashflows for Front End Loader
Year	Net Cashflow	PVf@10%	PV of Cashflows
1	$ 1,22,000.00	0.909091	$    1,10,909.09
2	$ 1,22,000.00	0.826446	$    1,00,826.45
3	$ 1,22,000.00	0.751315	$       91,660.41
4	$ 1,22,000.00	0.683013	$       83,327.64
5	$ 1,22,000.00	0.620921	$       75,752.40
	Present Value of Cash Inflows		$    4,62,475.99
	Present Value of Cash Outflows		$    4,60,000.00
	NPV of Project		$         2,475.99
Calculation of PV of Cashflows for Green House
Year	Net Cashflow	PVf@10%	PV of Cashflows
1	$ 1,95,000.00	0.909091	$    1,77,272.73
2	$ 1,65,000.00	0.826446	$    1,36,363.64
3	$ 1,16,000.00	0.751315	$       87,152.52
4	$    79,000.00	0.683013	$       53,958.06
5	$    55,000.00	0.620921	$       34,150.67
	Present Value of Cashflows		$    4,88,897.62
	Present Value of Cash Outflows		$    4,60,000.00
	NPV of Project		$       28,897.62

Question 2

The front-end loader NPV is low because 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.