Question

Capital Rationing Decision for a Service Company Involving Four Proposals

Renaissance Capital Group is considering allocating a limited amount of capital investment funds among four proposals. The amount of proposed investment, estimated operating income, and net cash flow for each proposal are as follows:

	Investment	Year		Operating Income		Net Cash Flow
Proposal A:	$680,000	1		$ 64,000		$ 200,000
		2		64,000		200,000
		3		64,000		200,000
		4		24,000		160,000
		5		24,000		160,000
				$240,000		$ 920,000
Proposal B:	$320,000	1		$ 26,000		$ 90,000
		2		26,000		90,000
		3		6,000		70,000
		4		6,000		70,000
		5		(44,000)		20,000
				$ 20,000		$340,000
Proposal C:	$108,000	1		$ 33,400		$ 55,000
		2		31,400		53,000
		3		28,400		50,000
		4		25,400		47,000
		5		23,400		45,000
				$142,000		$ 250,000
Proposal D:	$400,000	1		$100,000		$ 180,000
		2		100,000		180,000
		3		80,000		160,000
		4		20,000		100,000
		5		0		80,000
				$300,000		$700,000

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.

Present Value of $1 at Compound Interest
Year	6%	10%	12%	15%	20%
1	0.943	0.909	0.893	0.870	0.833
2	0.890	0.826	0.797	0.756	0.694
3	0.840	0.751	0.712	0.658	0.579
4	0.792	0.683	0.636	0.572	0.482
5	0.747	0.621	0.567	0.497	0.402
6	0.705	0.564	0.507	0.432	0.335
7	0.665	0.513	0.452	0.376	0.279
8	0.627	0.467	0.404	0.327	0.233
9	0.592	0.424	0.361	0.284	0.194
10	0.558	0.386	0.322	0.247	0.162

Required:

1. Compute the cash payback period for each of the four proposals.

	Cash Payback Period
Proposal A	3 years 6 months
Proposal B	4 years
Proposal C	2 years
Proposal D	2 years 3 months

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. If required, round your answers to one decimal place.

	Average Rate of Return
Proposal A	%
Proposal B	%
Proposal C	%
Proposal D	%

3. Using the following format, summarize the results of your computations in parts (1) and (2) by placing the calculated amounts in the first two columns on the left and indicate which proposals should be accepted for further analysis and which should be rejected. If required, round your answers to one decimal place.

Proposal	Cash Payback Period	Average Rate of Return		Accept or Reject
A	3 years, 6 months	%		Reject
B	4 years	%		Reject
C	2 years	%		Accept
D	2 years, 3 months	%		Accept

4. For the proposals accepted for further analysis in part (3), compute the net present value. Use a rate of 15% and the present value of $1 table above. Round to the nearest dollar.

Select the proposal accepted for further analysis.	Proposal C	Proposal D
Present value of net cash flow total	$	$
Less amount to be invested
Net present value	$	$

5. Compute the present value index for each of the proposals in part (4). If required, round your answers to two decimal places.

Select proposal to compute Present value index.	Proposal C	Proposal D
Present value index (rounded)

6. Rank the proposals from most attractive to least attractive, based on the present values of net cash flows computed in part (4).

Rank 1st	Proposal D
Rank 2nd	Proposal C

7. Rank the proposals from most attractive to least attractive, based on the present value indexes computed in part (5).

Rank 1st	Proposal C
Rank 2nd	Proposal D

8. The analysis indicates that although Proposal D  has the larger net present value, it is not as attractive as Proposal C  in terms of the amount of present value per dollar invested. Proposal D  requires the larger investment. Thus, management should use investment resources for Proposal C  before investing in Proposal D , absent any other qualitative considerations that may impact the decision.

Answer 1

SOLUTION

1.		Payback Period
			Proposal A:	3	-year,	6	-month cash payback period
							Net Cash		Cumulative
		Year and Months				Flow		Net Cash Flows
		Year 1	full year				$     200,000		$    200,000
		Year 2	full year				200,000		400,000
		Year 3	full year				200,000		600,000
		Year 4	6 months				80,000		680,000
			Proposal B:	4	-year,	0	-month cash payback period
							Net Cash		Cumulative
		Year and Months				Flow		Net Cash Flows
		Year 1	full year				$       90,000		$     90,000
		Year 2	full year				90,000		180,000
		Year 3	full year				70,000		250,000
		Year 4	full year				70,000		320,000
			Proposal C:	2	-year,	0	-month cash payback period
							Net Cash		Cumulative
		Year and Months				Flow		Net Cash Flows
		Year 1	full year				$       55,000		$     55,000
		Year 2	full year				53,000		108,000
		Year 3	N/A				-		-
		Year 4	N/A				-		-
			Proposal D:	2	-year,	3	-month cash payback period
							Net Cash		Cumulative
		Year and Months				Flow		Net Cash Flows
		Year 1	full year				$     180,000		$    180,000
		Year 2	full year				180,000		360,000
		Year 3	3 months				40,000		400,000
		Year 4	N/A				-		-