Theaverage rate of returnis another method that does not use present value and is commonly used in making capital investment decisions. Unlike the cash payback method, the average rate of return focuses on income rather than cash flow.

Assume that the investment involves an initial outlay of $100,000 with a five-year useful life and no salvage value under straight-line depreciation. The revenues are as follows: Year 1 - $20,000, Year 2 - $30,000, Year 3 - $40,000, Year 4 - $50,000 and Year 5 - $60,000.

Use the minus sign to indicate a net loss. If an amount is zero, enter "0".

Year Revenues Expenses Net Income

Year 1 net income (loss) = $20,000 - $20,000 = $-0

Year 2 net income (loss) = 30,000 - 20,000 = 10,000

Year 3 net income (loss) = 40,000 - 20,000 = 20,000

Year 4 net income (loss) = 50,000 - 20,000 = 30,000

Year 5 net income (loss) = 60,000 - 20,000 = 40,000

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Total Net income (five years) = $100,000

Average net income =. $100,000

___________ =. $_____________

Average Rate of Return = $20,000

__________ = _____________%

Present Value Index

When funds for capital investments are limited, projects can be ranked using apresent value index. A project with a negative net present value will have a present value index below 1.0. Also, it is important to note that a project with the largest net present value may, in fact, return a lower present value per dollar invested.

Let's look at an example of how to determine the present value index.

The company has a project with a 5-year life, an initial investment of $220,000, and is expected to yield annual cash flows of $55,000. Whathat is the present value index of the project if the required rate of return is set at 10%?

Present value index = $_______________

$220,000 = 0.95

McCall Corporation is looking to invest in Project A or Project B. The data surrounding each project is provided below. McCall's cost of capital is 11%.

Project A

This project requires an initial investment of $172,500. The project will have a life of 6 years. Annual revenues associated with the project will be $130,000andexpenses associated with the project will be $35,000.

Project B

This project requires an initial investment of $172,500. The project will have a life of 6 years. Annual revenues associated with the project will be $130,000andexpenses associated with the project will be $35,000.This project requires an initial investment of $130,000. The project will have a life of 4 years. Annual revenues associated with the project will be $111,000andexpenses associated with the project will be $60,000.

Calculate thenet present valueand thepresent value indexfor each project using the present value tables provided below.

Present Value of $1 (a single sum) at Compound Interest.

Present Value of an Annuity of $1 at Compound Interest.

Note:Use a minus sign to indicate a negative NPV.If an amount is zero, enter "0".Enter the present value index to 2 decimals.

Project A Project B

Total Present value of net cash flow $__________ $__________

Amount to be invested 172,500 130,000

Net Present value $__________ $____________