Question

Madison Capital Group is considering allocating a limited amount of capital investment funds among four proposals. The amount of proposed investment, estimated income from

operations, and net cash flow for each proposal are as follows:

 

 

The company's capital rationing policy requires a maximum cash payback period of three years. In addition, a minimum average rate of return of 12% is required on all projects. If the preceding standards are met, the net present value method and present value indexes are used to rank the remaining proposals.

Instructions
1. Compute the cash payback period for each of the four proposals.
2. Giving effect to straight-line depreciation on the investments and assuming no estimated residual value, compute the average rate of return for each of the four proposals. Round to one decimal place.
3. Using the following format, summarize the results of your computations in parts (1) and (2). By placing a check mark in the appropriate column at the right, indicate which proposals should be accepted for further analysis and which should be rejected.

 

4. For the proposals accepted for further analysis in part (3), compute the net present value
.
Use a rate of 12% and the present value of $1 table appearing in this chapter. Round to the nearest dollar.
5. Compute the present value index for each of the proposals in part (4). Round to two decimal places.
6. Rank the proposals from most attractive to least attractive, based on the present values of net cash flows computed in part (4).
7. Rank the proposals from most attractive to least attractive, based on the present value indexes computed in part (5).
8. Based upon the analyses, comment on the relative attractiveness of the proposals ranked in parts (6) and(7).

Answer 1

1. Proposal A: 4-year cash payback period, as follows:

   Net Cash Cumulative

  Year Flow   Net Cash Flows

 

   1 $150,000 $150,000

   2   150,000   300,000

   3   150,000   450,000

   4 90,000   540,000

 

   Proposal B: 2-year, 9-month cash payback period, as follows:

 

   Net Cash Cumulative

  Year Flow   Net Cash Flows

 

   1 $100,000 $100,000

   2 90,000   190,000

   9 months*    60,000   250,000

 

  *The cash flow required for investment payback in year 3 is $60,000, which is three-fourths ($60,000/$80,000) of year 3's cash flow. Thus, 9 months (three-fourths of 12 months) are needed to accumulate an additional $60,000.

 

   Proposal C: 3-year cash payback period, as follows:

 

   Net Cash Cumulative

  Year Flow   Net Cash Flows

 

   1 $220,000 $220,000

   2   210,000   430,000

   3   210,000   640,000

 

   Proposal D: 3-year, 4-month cash payback period, as follows:

 

Net Cash   Cumulative

  Year Flow   Net Cash Flows

 

   1 $130,000 $130,000

   2   100,000   230,000

   3 60,000   290,000

   4 months*    20,000   310,000

*The cash flow required for investment payback in year 4 is $20,000, which is one-third ($20,000/$60,000) of year 4's cash flow. Thus, 4 months (one-third of 12 months) are needed to accumulate an additional $20,000.

 

2. Proposal A: 6.7% average rate of return, determined as follows:

 

3. Of the four proposed investments, only Proposals B and C meet the company's requirements, as the following table indicates:

Cash Payback Average Rate Accept for

Proposal   Period   of Return Further Analysis Reject

 

   A   4 yrs.   6.7%   X

   B   2 yrs., 9 mos.   24.0 X

   C   3 yrs.    21.9 X

   D   3 yrs., 4 mos.   12.9   X*

 

*Proposal D is rejected because it fails to meet the maximum payback period requirement, even though it meets the minimum accounting rate of return requirement.

 

4.

Proposal B:

 

Present Value   Net Cash    Present Value of

Year of $1 at 12%    Flow Net Cash Flow

 

1 0.893    $100,000   $ 89,300

2 0.797    90,000 71,730

3 0.712    80,000 56,960

4 0.636    65,000 41,340

5 0.567     65,000     36,855

Total.........................................................................   $400,000    $296,185

Amount to be invested................................................................................. 250,000

Net present value.......................................................................................... $ 46,185

 

Proposal C:

 

Present Value   Net Cash    Present Value of

Year of $1 at 12%    Flow Net Cash Flow

 

1 0.893    $220,000    $196,460

2 0.797 210,000   167,370

3 0.712 210,000   149,520

4 0.636 190,000   120,840

5 0.567   160,000     90,720

Total.........................................................................   $990,000    $724,910

Amount to be invested................................................................................. 640,000

Net present value.......................................................................................... $ 84,910

 

 

5.

   *Rounded.

 

6. Based upon the net present value, the proposals should be ranked as follows:

   Proposal C: $84,910

   Proposal B: $46,185

 

7. Based upon the present value index (the amount of present value per dollar invested), the proposals should be ranked as follows:

   Proposal B: 1.18

   Proposal C: 1.13

 

8. The present value indexes indicate that although Proposal C has the larger net present value, it is not as attractive as Proposal B in terms of the amount of present value per dollar invested. Proposal C requires the larger investment. 

 

Thus, management should use investment resources for Proposal B before investing in Proposal C.