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 straight line depreciation method is used.
Project 1: Retooling Manufacturing Facility
This project would require an initial investment of $5,800,000. It would generate $1,036,000 in additional net cash flow each year. The new machinery has a useful life of eight years and a salvage value of $1,228,000.
Project 2: Purchase Patent for New Product
The patent would cost $4,065,000, which would be fully amortized over five years. Production of this product would generate $894,300 additional annual net income for Hearne.
Project 3: Purchase a New Fleet of Delivery Trucks
Hearne could purchase 25 new delivery trucks at a cost of $210,000 each. The fleet would have a useful life of 10 years, and each truck would have a salvage value of $6,900. Purchasing the fleet would allow Hearne to expand its customer territory resulting in $1,155,000 of additional net income per year.
1. Determine each project's accounting rate of return,and determine each project's payback period.
2(a) Using a discount rate of 10 percent, calculate the net present value of each project. (Future Value of $1, Present Value of $1, Future Value Annuity of $1, Present Value Annuity of $1.)
2(b) Determine the profitability index of each project and prioritize the projects for Hearne.