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Accounting

27th Edition
WARREN + 5 others
ISBN: 9781337272094

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BuyFindarrow_forward

Accounting

27th Edition
WARREN + 5 others
ISBN: 9781337272094
Textbook Problem

Average rate of return method, net present value method, and analysis

 The capital investment committee of Nature's Portrait 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 Fixtures
Year Income from Operations Net Cash Flow Income from Operations Net Cash Flow
1 $25,000 $ 40,000 $11,250 $ 26,250
2 20,000 35,000 11,250 26,250
3 7,000 22,000 11,250 26,250
4 3,000 18,000 11,250 26,250
5 1,250 16,250 11,250 26,250
Total $56,250 $131,250 $56,250 $131,250

 Each project requires an investment of $75,000. Straight-line depreciation will be used, and no residual value is expected. The committee has selected a rate of 12% for purposes of the net present value analysis.

Instructions

 1. Compute the following:

  1. a. The average rate of return for each investment. Round to one decimal place.
  2. b. The net present value for each investment. Use the present value of $1 table appearing in this chapter (Exhibit 2). Round present values to the nearest dollar.

 2. Prepare a brief report for the capital investment committee, advising it on the relative merits of the two investments.

1. a.

To determine

Average Rate of Return:

Average rate of return is a method that measures the average earnings of a particular business, as a percentage of the average investment. It is also known as accounting rate of return.

Calculation of Average rate of return:

AverageRateofReturn}=(EstimatedAverageAnnualIncome)(AverageInvestment)×100

To determine: The average rate of return for each project.

Explanation

The average rate of return for each project is 30%.

Working Notes:

Since the annual income and investment of each project are same, so the average rate of return will also be the same.

Calculation of Average Rate of Return:

AverageRateofReturn}=(EstimatedAverageAnnualIncome)(AverageInvestment)×100=($11,250)($37,500)×100=30%

(Refer equation (1) and (2) of the working notes)

Calculation of Average Annual Income:

b.

To determine

Net present value method:

Net present value method is the method which is used to compare the initial cash outflow of investment with the present value of its cash inflows. In the net present value, the interest rate is determined by the business, based on the net income from the investment, and it is also called as the discounted cash flow method.

To determine: The net present value of each investment, using the present value of $1 table in Exhibit 2.

2.

To determine

To prepare: The report the merits of the two investments to the capital investment committee.

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