Question

Excess Present Value Index and Average Rate of Return
Highpoint Company is evaluating five different capital expenditure proposals. The company's hurdle rate for net present value analyses is 12%. A 10% salvage value is expected from each of the investments. Information on the five proposals is as follows:

Proposal	Required Investment	PV at 12% of After-Tax Cash Flows	Avg. Annual Net Income from Investment
A	$285,000	$325,030	$37,400
B	215,000	251,780	26,000
C	175,000	188,040	19,200
D	195,000	231,300	27,600
E	143,000	151,990	14,960

a. Compute the excess present value index for each of the five proposals.
Round answers to three decimal places.

Proposal	Excess PV Index
A	Answer
B	Answer
C	Answer
D	Answer
E	Answer

b. Compute the average rate of return for each of the five proposals.
Round answers to one decimal place. For example, 0.4567 equals 45.7%

Proposal	Avg. Rate of Return
A	Answer
B	Answer
C	Answer
D	Answer
E	Answer

c. Assume that Highpoint will commit no more than $500,000 to new capital expenditure proposals.

Using the excess present value index, which proposals would be accepted. Select the best answer.

AnswerProposals A and BProposals B and EProposals B and DProposals C and EProposals A and D

Now using the average rate of return, which proposals would be accepted? Select the best answer.

AnswerProposals A and BProposals B and EProposals B and DProposals C and EProposals A and D

Answer 1

The part a) is solved below:

Proposal	Required investment (A)	PV at 12% of After-Tax Cash (B)	Profitability index (B/A)
A	$285,000	$325,030	1.14
B	$215,000	$251,780	1.17
C	$175,000	$188,040	1.07
D	$195,000	$231,300	1.19
E	$143,000	$151,990	1.06

The part b) is solved below:

Proposal	Avg. Annual Net Income (A)	Average investment (B)	Avg. Rate of Return (A/B)
A	$37,400	$156,750	23.86%
B	$26,000	$118,250	22%
C	$19,200	$96,250	19.95%
D	$27,600	$107,250	25.73%
E	$14,960	$78,650	19.02%

Average investment = (Investment cost + Salvage value) / 2

A = $285,000 * (1 + 10%) / 2 = $156,750

B = $215,000 * (1 + 10%) / 2 = $11,8250

A = $175,000 * (1 + 10%) / 2 = $96,250

A = $195,000 * (1 + 10%) / 2 = $107,250

A = $143,000 * (1 + 10%) / 2 = $78,650

Part c) Assuming that Highpoint will commit no more than $500,000 to new capital expenditure proposals,

Using the PI index, Project B and D should be taken up.

Using the average rate of return, Project A and D should be taken up.