Question

Capital Rationing Decision for a Service Company Involving Four Proposals

Clearcast Communications Inc. 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:	$450,000	1		$30,000		$120,000
		2		30,000		120,000
		3		20,000		110,000
		4		10,000		100,000
		5		(30,000)		60,000
				$60,000		$510,000
Proposal B:	$200,000	1		$60,000		$100,000
		2		40,000		80,000
		3		20,000		60,000
		4		(10,000)		30,000
		5		(20,000)		20,000
				$90,000		$290,000
Proposal C:	$320,000	1		$36,000		$100,000
		2		26,000		90,000
		3		26,000		90,000
		4		16,000		80,000
		5		16,000		80,000
				$120,000		$440,000
Proposal D:	$540,000	1		$92,000		$200,000
		2		72,000		180,000
		3		52,000		160,000
		4		12,000		120,000
		5		(8,000)		100,000
				$220,000		$760,000

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:	4 years
Proposal B:	2 years, 4 months
Proposal C:	3 years, 6 months
Proposal D:	3 years

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	4 years		%	Reject
B	2 years, 4 months		%	Accept
C	3 years, 6 months		%	Reject
D	3 years		%	Accept

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 above. Round to the nearest dollar.

Select the proposal accepted for further analysis.	Proposal B	Proposal D
Present value of net cash flow total	$	$
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 B	Proposal D
Present value index (rounded)

Answer 1

1. cash payback period

	Investment			Year			cummulative Cash Flow
Proposal A:	$450,000			1			$120,000
				2			240000 [120000+120000]
				3			350000 [240000+110000]
				4			450000
				5			510000

initial investment will covered in 4th year

so payback period is 4years

				cummulative cash flow
Proposal B:	$200,000	1		$100,000
		2		1,80,000
		3		240000 [180000+60000]
		4		270000
		5		290000

year before cash recovery + unrecovered cash/ cash flow in next period

=2 + [200000-180000]/60000

=2+0.33 =2+ (12months*0.33)

=2 year 4months

			cummulative cash flow
Proposal C:	$320,000	1	$100,000
		2	1, 90,000
		3	280000[190000+90000]
		4	360000 [280000+80000]
		5	440000 [360000+80000]

= 3 + [320000-280000]/80000

=3 years 6 months

Proposal D:	$540,000	1	$200,000
		2	380,000[200000+180000]
		3	540000
		4	660000
		5	760000

3 years 540000 initial outflow will be covered back.

2]average rate of return = average income/ average investment

A = 60000/5=12000 average income

investment = 450000+0salvage/2

=225000

average rate of return = 12000/225000

=5.33%

B =90000/5 ] / [200000/2]

=18000/100000

=18%

C=[120000/5]/[320000/2]

=24000/160000

=15%

D=[220000/5]/[540000/2]

=44000/270000

=16.30%

3]

Proposal	Cash Payback Period	Average Rate of Return		Accept or Reject
A	4 years	5.33	%	Reject
B	2 years, 4 months	18	%	Accept
C	3 years, 6 months	15	%	Reject
D	3 years	16.30	%	Accept

4]

Select the proposal accepted for further analysis.	Proposal B	Proposal D
Present value of net cash flow total	$226200	$569000
Amount to be invested	$(200000)	$(540000)
Net present value	$26200	$29000

			PV FACTOR	NET CASH FLOW	PRESENT VALUE OF CASH FLOW
Proposal B:	$200,000	1	0.893	$100,000	89300
		2	0.797	80,000	63760
		3	0.712	60,000	42720
		4	0.636	30,000	19080
		5	0.567	20,000	11340
				PRESENT VALUE	226200

				PV FACTOR	NET CASH FLOW	PRESENT VALUE
Proposal D:	$540,000	1		0.893	$200,000	178600
		2		0.797	180,000	143460
		3		0.712	160,000	113920
		4		0.636	120,000	76320
		5		0.567	100,000	56700
					TOTAL	569000

5.PROFITABILITY INDEX = PRESENT VALUE OF NET CASH INFLOW/ CASH OUTFLOW

B =226200/200000

=1.13

D= 569000/540000

=1.05