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 the straight-line depreciation method is used.

Project 1: Retooling

This project would require an initial investment of $4,850,000. It would generate $865,000 in additional net cash flow each year. The new machinery has a useful life of eight years and a salvage value of $1,000,000.

Project 2: Patent

The patent would cost $3,400,000, which would be fully amortized over five years. Production of this product would generate $425,000 additional annual net income for Hearne.

Project 3: Purchase Trucks

Hearne could purchase 25 new delivery trucks at a cost of $115,000 each. The fleet would have a useful life of 10 years, and each truck would have a salvage value of $5,000. Purchasing the fleet would allow Hearne to expand its customer territory resulting in $200,000 additional net income per year.

Calculate Annual Net Income = Annual Cash Flow - Depreciation

= [$865,000 - (($4,850,000 - 1,000,000)/8 years)]

= $383,750

Project 1:

Accounting Rate of Return = Annual Net Income / Initial Investment

= $383,750 / $4,850,000

= 7.91%

Project 2:

Accounting Rate of Return = Annual Net Income / Initial Investment

= $425,000 / $3,400,000

= 12.50%

Project 3:

Accounting Rate of Return = Annual Net Income / Initial Investment

= $200,000 / $2,875,000

= 6.96%

Based on the accounting rates of return, Project 2 is the best. Project 1 is the second best, while Project 3 gives the lowest accounting rate of return.

Calculate the Payback Period:

Project 1: Payback period = Initial Investment / Annual Net Cash Flow

= $4,850,000 / $865,000

= 5.61 years

Project 2: Payback period = Initial Investment / Annual Net Cash Flow

= Initial Investment / (Net Income + Depreciation)

= $3,400,000 / [$425,000 + ($3,400,000 / 5)]

= $3,400,000 / $1,105,000

= 3.08 years

Project 3: Payback period = Initial Investment / Annual Net Cash Flow

= Initial Investment / (Net Income + Depreciation)

= $2,875,000 / ($200,000 + [($2,875,000 - $125,000) / 10])

= $2,875,000 / $475,000

= 6.05 years

Based on the payback period, Project 2 is preferred. Project 1 is the second preference, and project 3 has the longest payback period.

Using a discount rate of 10%, calculate the net present value of each project:

Project 1:

Year Annual Cash Flow PV Factor (10%) Present Value

0 $(4,850,000) 1.0000 $(4,850,000.00)

1-8 865,000 5.3349 4,614,688.50

8 1,000,000 0.4665 466,500.00

NPV $231,188.50

Project 2:

Year Annual Cash Flow PV Factor (10%) Present Value

0 $(3,400,000) 1.0000 $(3,400,000.00)

1-5 1,105,000* 3.7908 4,188,834.00

5 0 --- 0

NPV $788,834

*Annual Cash Flow = $425,000 + (3,400,000 / 5)

Project 3:

Year Annual Cash Flow PV Factor (10%) Present Value

0 $(2,875,000) 1.0000 $(2,875,000)

1-10 475,000 6.1446 2,918,685

10 125,000 0.3855 48,187.50

NPV $91,872.50

*Annual Cash Flow = $200,00 + [($2,875,000 - $125,000) / 10]

Determine the Profitability Index of each product and prioritize the projects for Hearne:

Profitability Index = Present Value of Future Cash Flows / Initial Investment

Project 1:

Profitability Index = $5,081,188.50 / $4,850,000 = 1.0477

Project 2:

Profitability Index = $4,188,834 / $3,400,000 = 1.2320

Project 3:

Profitability Index = $2,966,872.50 / $2,875,000 = 1.0320

Prioritize Project 2, then Project 1, then Project 3.

	Created by Mariah Bruce about 4 years ago

Accounting (Capital Budgeting) Note on Time Value of Money, created by Mariah Bruce on 05/06/2020.