McEntyre Company has $80,000 in capital funds available for investment. The capital investment committee at McEntyre Company is currently considering two capital investment projects.
The estimated income from operations and net cash flows expected from each project are as follows:
Project A Project B
Year Income from Operations Net Cash Flow Income from Operations Net Cash Flow
1 $ 8,000 $24,000 $ 14,000 $ 30,000
2 9,000 25,000 10,000 26,000
3 11,000 27,000 8,000 24,000
4 8,000 24,000 7,000 23,000
5 8,000 24,000 3,000 19,000
$44,000 $124,000 $42,000 $122,000
Each project requires an investment of $80,000. Straight-line depreciation will be used, and no residual value is expected. The committee has selected a rate of 20% as the minimum average rate of return for capital investments.
Analyze the projects and prepare a report for the capital investment committee, advising it of the relative merits of each project.
In your paper,
Explain the purpose of the report and describe the nature and importance of capital investment analysis.
Analyze each long-term capital investment project based on the average rate of return.
Compute the average rate of return for each project and show your work.
Determine whether each project meets the minimum average rate of return required by the committee.
Discuss the advantages and disadvantages of the average rate of return method.
Rank the projects based on average rate of return.
Analyze each project based on cash payback period.
Determine the cash payback period for each project. Assume that net cash flows for both projects are uniform throughout the year.
Discuss the advantages and disadvantages of the cash payback method.
Rank the projects based on the cash payback period.
Discuss at least three factors that could potentially complicate your capital investment analysis.
Summarize your analysis and make a recommendation to the capital investment committee regarding which project the committee should fund.
Full Answer Section
Analysis Based on Average Rate of Return (ARR)
Average Rate of Return (ARR) is a profitability measure that calculates the average annual return on investment over the project's life. It is computed using the following formula:
ARR = (Average Annual Net Cash Flow / Initial Investment) x 100%
Project A:
- Average Annual Net Cash Flow = ($124,000 total net cash flow) / 5 years = $24,800
- ARR = ($24,800 / $80,000) x 100% = 31.00%
Project B:
- Average Annual Net Cash Flow = ($122,000 total net cash flow) / 5 years = $24,400
- ARR = ($24,400 / $80,000) x 100% = 30.50%
Interpretation:
Both Project A (31.00%) and Project B (30.50%) exceed the minimum required average rate of return of 20%.
Advantages of ARR:
- Simple to understand and calculate.
- Considers all cash flows over the project's life cycle.
Disadvantages of ARR:
- Ignores the time value of money (earlier cash flows are considered less valuable than later ones).
- Doesn't explicitly account for risk.
Ranking Based on ARR:
- Project A (31.00%)
- Project B (30.50%)
Analysis Based on Cash Payback Period
Cash Payback Period is the time it takes to recover the initial investment from the project's net cash flows.
Calculation:
We need to calculate the cumulative net cash flow until it reaches $80,000 (initial investment).
Project A:
- Year 1: $24,000
- Year 2: $24,000 + $25,000 = $49,000 (still not enough to recover investment)
- Year 3: $49,000 + $27,000 = $76,000 (need $4,000 more to recover investment)
- Cash Payback Period = 2 years + ($4,000 / $24,000) = 2.17 years
Project B:
- Year 1: $30,000
- Year 2: $30,000 + $26,000 = $56,000 (still not enough to recover investment)
- Year 3: $56,000 + $24,000 = $80,000 (recovered investment in year 3)
- Cash Payback Period = 3 years
Interpretation:
Project A has a faster cash payback period (2.17 years) compared to Project B (3 years).
Advantages of Cash Payback Period:
- Easy to understand and calculate.
- Focuses on short-term cash flow recovery.
Disadvantages of Cash Payback Period:
- Ignores cash flows after the payback period.
- Doesn't consider the time value of money.
Ranking Based on Cash Payback Period:
- Project A (2.17 years)
- Project B (3 years)
Factors Complicating Capital Investment Analysis
- Uncertainty about future cash flows: Economic fluctuations, changes in market demand, and unforeseen events can impact future cash flows.
- Project risk: Factors like technological advancements, competition, and regulatory changes can affect project outcomes.
- Qualitative factors: Strategic considerations, environmental impact, and employee morale might not be fully captured by financial metrics alone.
Recommendation
Based on both ARR and cash payback period, Project A appears to be the more favorable option. It offers a higher average rate of return (exceeding the minimum requirement by a larger margin) and a faster payback period.
Sample Answer
Capital Investment Project Analysis Report
To: Capital Investment Committee, McEntyre Company
From: [Your Name], Analyst
Date: June 25, 2024
Subject: Analysis of Capital Investment Projects A and B
Purpose
This report analyzes two potential capital investment projects, Project A and Project B, for McEntyre Company. Capital investment analysis is crucial for making informed decisions about allocating resources for long-term projects. It helps assess the financial viability, profitability, and risk associated with each investment option.