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 $5,450,000. It would generate $973,000 in additional net cash flow each year. The new machinery has a useful life of eight years and a salvage value of $1,144,000. Project 2: Purchase Patent for New Product The patent would cost $3,820,000, which would be fully amortized over five years. Production of this product would generate $706,700 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 $175,000 each. The fleet would have a useful life of 10 years, and each truck would have a salvage value of $6,200. Purchasing the fleet would allow Hearne to expand its customer territory resulting in $809.400 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 Years Project 1 Project 2 Project 3 Years Activate Windows Years Go to Settings to activate Windows.

Answer 1

Accounting rate of return = Net Income / Investment x 100
Payback Period = Investment / Additional Net Cash flow for each year
NPV = PV of Cash Inflows + PV of salvage - Investment
Profitability Index = Present Value / Investment

Project 1
Investment = $5450000
Depreciation = ($5450000-1144000) / 8 = $538250
Additional net cash flow for each year = $973000
Net Income = $973000 - $538250 = $434750

Accounting Rate of Return = $434750 / $5450000 x 100 = 7.98%

Payback period = $5450000 / $973000 = 5.60 years

NPV
PV annuity @10% for 8 years = 5.3353, PV factor @10% for 8th year = 0.4665
NPV = $973000 x 5.3353 + $1144000 x 0.4665 - $5450000 = $274923

Profitability Index = ($973000 x 5.3353 + $1144000 x 0.4665) / $5450000 = 1.05

Project 2
Investment = $3820000
Amortization = $3820000 / 5 = $764000
Net Income = $706700
Additional net cash flow for each year = $706700 + $764000 = $1470700

Accounting Rate of Return = $706700 / $3820000 x 100 = 18.50%

Payback period = $3820000 / $1470700 = 2.60 years

NPV
PV annuity @10% for 5 years = 3.7911
NPV = $1470700 x 3.7911 - $3820000 = $1755571

Profitability Index = ($1470700 x 3.7911) / $3820000 = 1.46

Project 3
Investment = $175000 x 25 = $4375000
Depreciation = ($4375000-155000) / 10 = $422000
Net Income = $809400
Additional net cash flow for each year = $809400 + $422000 = $1231400

Accounting Rate of Return = $809400 / $4375000 x 100 = 18.50%

Payback period = $4375000 / $1231400 = 3.55 years

NPV
PV annuity @10% for 10 years = 6.1449, PV factor @10% for 10th year = 0.3855
NPV = $1231400 x 6.1449 + $155000 x 0.3855 - $4375000 = $3251582

Profitability Index = ($1231400 x 6.1449 + $155000 x 0.3855) / $4375000 = 1.74

Ranking as on profitability index
Project 1 = Rank 3
Project 2 = Rank 2
Project 3 = Rank 1