Question

STEPS IN THE CAPITAL RATIONING PROCESS

Step 1:  Identify potential capital investment projects.

Step 2:  Establish a minimum average rate of return and/or a maximum desired cash payback period to screen the projects. Eliminate any project that fails to meet these standards, unless the project has overriding qualitative benefits.

Step 3:  Evaluate the remaining projects, using net present value and/or internal rate of return techniques.

Step 4:  Consider the qualitative benefits of each project.

Step 5:  Rank the projects, based on the results of Steps 3 and 4.

Step 6:  Allocate available funds, beginning with the top-ranked project.

Handout 25(11)-1

Capital Rationing

Plasticon manufactures plastic containers used to package a variety of liquid consumer products (such as fabric softener, cleaners, shampoo, hair spray, and liquid soap). The containers are manufactured on a job-order basis to customer specifications.

Plasticon has received five proposals for capital investment projects. Your job is to evaluate these proposals and rank them in the order in which they should be funded. Begin your analysis by computing the average rate of return and cash payback period for each proposal. Any project that has an average rate of return of less than 15% or a cash payback period of longer than five years should be eliminated from further consideration. After this initial screening, compute the net present value (using a 15% discount rate) and internal rate of return for the remaining projects. Rank the projects based on both their profitability and overall merit to the corporation (qualitative factors).

                                                Project A       Project B      Project C       Project D      Project E

Cost                                          $200,000       $250,000      $325,000       $500,000       $400,000

Expected useful life                     8 years        10 years       10 years        10 years          8 years

Residual value                                    $0                  $0                 $0                  $0                  $0

Annual project income               $17,000         $18,000        $33,000         $55,000         $45,000

Annual net cash inflow               $42,000         $43,000        $65,500       $105,000         $95,000

            

Project A: This proposal requests funds to purchase hardware and software that will allow the Accounting Department to process payroll in-house. Paychecks are currently processed by an outside payroll service company. The annual increase in net income and cash flows will result from cost savings if the payroll function is no longer contracted to an outside company.

Project B: This proposal requests funds for new manufacturing equipment. This equipment will allow Plasticon to make containers as large as ten gallons. Currently, Plasticon can not make containers that are larger than three gallons.

Project C: This proposal requests funds for equipment to make stick-on labels that are applied to the plastic containers. Currently, all stick-on labels are ordered from another company. This supplier has not proven very reliable in meeting delivery deadlines.

Project D: This proposal requests funds for automated manufacturing equipment that will reduce the cycle time from receipt of a customer order to delivery of that order. Plasticon’s cycle time is currently seven days. The automated equipment will reduce that time to four days while saving costs due to the elimination of five jobs. It will also make Plasticon more competitive; the company’s major competitor currently has a cycle time of five days.

Project E: This proposal requests funds for computerized drafting and design equipment that will allow engineers to complete manufacturing instructions on special orders more quickly. This equipment should reduce Plasticon’s cycle time from seven to five days.

                  Present Value of an Annuity of $1 at Compound Interest           

Period        12%         13%           14%           15%         16%         17%      18%

                 8          4.968       4.799         4.639         4.487       4.344       4.207    4.078

               10          5.650       5.426         5.216         5.019       4.833       4.659    4.494

please use excel to complete.

Answer 1

Already Solved!

Part 1)

The average rate of return for each project is calculated with the use of following formula:

ARR = Annual Project Income/((Cost+Residual Value)/2)*100

Using the values provided in the question in the above formula, we get,

ARR (Project A) = 17,000/((200,000+0)/2)*100 = 17.00%

ARR (Project B) = 18,000/((250,000+0)/2)*100 = 14.40%  

ARR (Project C) = 33,000/((325,000+0)/2)*100 = 20.31%

ARR (Project D) = 55,000/((500,000+0)/2)*100 = 22.00%

ARR (Project E) = 45,000/((400,000+0)/2)*100 = 22.50%

_____

Part 2)

The cash payback period for each project is arrived as below:

Cash Payback Period = Cost/Annual Net Cash Flows

Using the values provided in the question in the above formula, we get,

Cash Payback Period (Project A) = 200,000/42,000 = 4.76 years  

Cash Payback Period (Project B) = 250,000/43,000 = 5.81 years

Cash Payback Period (Project C) = 325,000/65,500 = 4.96 years

Cash Payback Period (Project D) = 500,000/105,000 = 4.76 years

Cash Payback Period (Project E) = 400,000/95,000 = 4.21 years

_____

Part 3)

NPV is the difference between the present value of cash inflows and cash flows. It can be calculated with the use of following formula:

NPV = -Cost + Annual Net Cash Flow*PVIFA(Discount Rate,Life)

Using the information provided in the question, we get,

NPV (Project A) = -200,000 + 42,000*PVIFA(15%,8) = -200,000 + 42,000*4.487 = -$11,546

NPV (Project B) = -250,000 + 43,000*PVIFA(15%,10) = -250,000 + 43,000*5.019 = -$34,183

NPV (Project C) = -325,000 + 65,500*PVIFA(15%,10) = -325,000 + 65,500*5.019 = $3,744.50

NPV (Project D) = -500,000 + 105,000*PVIFA(15%,10) = - 500,000 + 105,000*5.019 = $26,995

NPV (Project E) = -400,000 + 95,000*PVIFA(15%,8) = -400,000 + 95,000*4.487 = $26,265

_____

Part 4)

IRR is the minimum rate of return acceptable from a project. It can be calculated with the use of IRR function/formula of EXCEL/Financial Calculator. The basic formula for calculating IRR is given as below:

NPV = 0 = -Cost + Cash Flow Year 1/(1+IRR)^1 + Cash Flow Year 2/(1+IRR)^2 + Cash Flow Year 3/(1+IRR)^3 + Cash Flow Year 4/(1+IRR)^4 + Cash Flow Year 5/(1+IRR)^5 + Cash Flow Year 6/(1+IRR)^6 + Cash Flow Year 7/(1+IRR)^7 + Cash Flow Year 8/(1+IRR)^8 + Cash Flow Year 9/(1+IRR)^9 + Cash Flow Year 10/(1+IRR)^10

IRR for all projects is calculated with the use of EXCEL as below:

where,

IRR(Project A) = IRR(B3:B11) = 13.23%

IRR(Project B) = IRR(C3:C13) = 11.31%

IRR (Project C) = IRR(D3:D13) = 15.30%

IRR (Project D) = IRR(E3:E13) = 16.40%

IRR (Project E) = IRR(F3:F11) = 16.97%

_____

Tabular Representation:

	Project A	Project B	Project C	Project D	Project E
Average Rate of Return	17.00%	14.40%	20.31%	22.00%	22.50%
Cash Payback Period	4.76	5.81	4.96	4.76	4.21
Net Present Value	-$11,546.00	-$34,183.00	$3,744.50	$26,995.00	$26,265.00
Internal Rate of Return	13.23%	11.31%	15.30%	16.40%	16.97%

The company can accept projects C, D and E because all of them have positive NPV. However, if the company has limited budget, it should accept the projects in the following order:

Project D	1
Project E	2
Project C	3