   Chapter 26, Problem 26.1BPR

Chapter
Section
Textbook Problem

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: Year Warehouse Tracking Technology Income from Operations Net Cash Flow Income from Operations Net Cash Flow 1 $61,400$135,000 $34,400$106,000 2 51,400 125,000 34,400 108,000 3 36,400 110,000 34,400 108,000 4 26,400 100,000 34,400 108,000 5 (3,600) 70,000 34,400 108,000 Total $172,000$540,000 $172,000$540,000  Each project requires an investment of $368,000. Straight-line depreciation will he used and no residual value is expected. The committee has selected a rate of 15% for purposes of the net present value analysis.Instructions 1. Compute the following: a. The average rate of return for each investment. Round to one decimal place. 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 projects.

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 18.7%.

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=($34,000)($184,000)×100=18

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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