Average Rate of Return Method Net Present Value Method and A

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:

Each project requires an investment of $420,000. Straight-line depreciation will be used, and no residual value is expected. The committee has selected a rate of 15% for purposes of the net present value analysis.

Required:

1a. Compute the average rate of return for each investment. If required, round your answer to one decimal place.

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.

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 earlier in time compared to the greenhouse. Thus, if only one of the two projects can be accepted, the greenhouse would be the more attractive.

	Front-End Loader		Greenhouse
Year	Income from Operations	Net Cash Flow		Income from Operations	Net Cash Flow
1	$42,000		$137,000			$88,000		$219,000
2	42,000		137,000			67,000		185,000
3	42,000		137,000			34,000		130,000
4	42,000		137,000			15,000		89,000
5	42,000		137,000			6,000		62,000
Total	$210,000		$685,000			$210,000		$685,000

Solution

1a          

Average Rate of Return

Front End Loader

Greenhouse

Total Cash flow in 5 years

$ 685,000.00

$           685,000.00

Number of years

5

5

Average return per year

$ 137,000.00

$           137,000.00

Average Return in %

33%

33%

1b

Front End Loader

Greenhouse

Present value of net Cash Flows

$ 459,245.25

$           497,509.47

Amount to be Invested

$ 420,000.00

$           420,000.00

Net Present value

$    39,245.25

$             77,509.47

Calculation of NPV step by step

Front-End Loader

Year

Net Cash Flow

Present value Discounting factor at 15%

Discounted Cash Flow

1

$ 137,000.00

0.870

$ 119,130.43

2

$ 137,000.00

0.756

$ 103,591.68

3

$ 137,000.00

0.658

$    90,079.72

4

$ 137,000.00

0.572

$    78,330.19

5

$ 137,000.00

0.497

$    68,113.21

Total Discounted Cash Flows

$ 459,245.25

Less: Cost of Investment

$ 420,000.00

Net Present Value

$    39,245.25

Greenhouse

Year

Net Cash Flow

Present value Discounting factor at 15%

Discounted Cash Flow

1

$219,000.00

0.870

$    190,434.78

2

$185,000.00

0.756

$    139,886.58

3

$130,000.00

0.658

$      85,477.11

4

$ 89,000.00

0.572

$      50,886.04

5

$ 62,000.00

0.497

$      30,824.96

Total Discounted Cash Flows

$    497,509.47

Less: Cost of Investment

$    420,000.00

Net Present Value

$      77,509.47

2

Conclusion

Both the Investments gives same rate of return but Green house gives more cash returns in earlier years and have more Net Present value than Front end Loader. Green House should be selected for Investment.

Average Rate of Return
	Front End Loader	Greenhouse
Total Cash flow in 5 years	$ 685,000.00	$           685,000.00
Number of years	5	5
Average return per year	$ 137,000.00	$           137,000.00
Average Return in %	33%	33%