Question 25.IP.1: The capital investment committee of Hopewell Company is curr...
The capital investment committee of Hopewell Company is currently considering two investments. The estimated income from operations and net cash flows expected from each investment are as follows:
|
Year |
Truck | Equipment | ||
| Income from operations | Net Cash Flow | Income from operations | Net Cash Flow | |
| 1 | $ 6,000 | $ 22,000 | $13,000 | $ 29,000 |
| 2 | 9,000 | 25,000 | 10,000 | 26,000 |
| 3 | 10,000 | 26,000 | 8,000 | 24,000 |
| 4 | 8,000 | 24,000 | 8,000 | 24,000 |
| 5 | 11,000 | 27,000 | 3,000 | 19,000 |
| \underline{\underline{\$ \ 44,000}} | \underline{\underline{\$ \ 124,000}} | \underline{\underline{\$ \ 42,000}} | \underline{\underline{\$ \ 122,000}} | |
Each investment requires $80,000. 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.
Instructions
1. Compute the following:
a. The average rate of return for each investment.
b. The net present value for each investment. Use the present value of $1 table appearing in this chapter (Exhibit 1).
| EXHIBIT 1 : Partial Present Value of $1 Table | |||||
| 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 |
2. Why is the net present value of the equipment greater than the truck, even though its average rate of return is less?
3. Prepare a summary for the capital investment committee, advising it on the relative merits of the two investments.
1. a. Average rate of return for the truck:
\frac{\$ 44,000 \div 5}{(\$ 80,000 + \$ 0) \div 2} = 22%
Average rate of return for the equipment:
\frac{\$ 42,000 \div 5}{(\$ 80,000 + \$ 0) \div 2} = 21%
b. Net present value analysis:
| Year | Present Value of $1 at 15% | Net Cash Flow | Present Value of Net Cash Flow | ||
| Truck | Equipment | Truck | Equipment | ||
| 1 | 0.870 | $ 22,000 | $ 29,000 | $19,140 | $25,230 |
| 2 | 0.756 | 25,000 | 26,000 | 18,900 | 19,656 |
| 3 | 0.658 | 26,000 | 24,000 | 17,108 | 15,792 |
| 4 | 0.572 | 24,000 | 24,000 | 13,728 | 13,728 |
| 5 | 0.497 | 27,000 | 19,000 | 13,419 | 9,443 |
| Total | \underline{\underline{\$ \ 124,000}} | \underline{\underline{\$ \ 122,000}} | $82,295 | $83,849 | |
| Less amount to be invested | 80,000 | 80,000 | |||
| Net present value | \underline{\underline{\$ \ 2,295}} | \underline{\underline{\$ \ 3,849}} | |||
2. The equipment has a lower average rate of return than the truck because the equipment’s total income from operations for the five years is $42,000, which is $2,000 less than the truck’s. Even so, the net present value of the equipment is greater than that of the truck, because the equipment has higher cash flows in the early years.
3. Both investments exceed the selected rate established for the net present value analysis. The truck has a higher average rate of return, but the equipment offers a larger net present value. Thus, if only one of the two investments can be accepted, the equipment would be the more attractive.