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 income from operations, and net cash flow for each proposal are as follows:
|
Investment
|
Year
|
|
Income from Operations
|
|
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: |
|
Proposal B: |
|
Proposal C: |
|
Proposal D: |
|
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: |
fill in the blank 5 % |
Proposal B: |
fill in the blank 6 % |
Proposal C: |
fill in the blank 7 % |
Proposal D: |
fill in the blank 8 % |
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
|
|
fill in the blank 10 |
% |
|
B
|
|
fill in the blank 13 |
% |
|
C
|
|
fill in the blank 16 |
% |
|
D
|
|
fill in the blank 19 |
% |
|
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.
Note:Select the proposals in alphabetic order.
Select the proposal accepted for further analysis. |
|
|
Present value of net cash flow total |
$fill in the blank 23 |
$fill in the blank 24 |
Less amount to be invested |
$fill in the blank 25 |
$fill in the blank 26 |
Net present value |
$fill in the blank 27 |
$fill in the blank 28 |
5.Compute the present value index for each of the proposals in part (4). If required, round your answers to two decimal places.
Note: Select the proposals in alphabetic order.
Select proposal to compute Present value index. |
|
|
Present value index (rounded) |
fill in the blank 31 |
fill in the blank 32 |
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.The present value indexes indicate that although Proposal has the larger net present value, it is not as attractive as Proposal in terms of the amount of present value per dollar invested. Proposal requires the larger investment. Thus, management should use investment resources for Proposal before investing in Proposal , absent any other qualitative considerations that may impact the decision.