Question

-NM PR 11-6B Capital rationing decision for a service company involving Obj. 2, 3,5 four proposals Clearcast Communications Inc. 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: Income from Net Cash Investment Year Operations Flow Proposal A: $450,000 $ 30,000 $120,000 30,000 120,000 20,000 110,000 10,000 100,000 (30,000) 60,000 $ 60,000 $510,000 Proposal B: $200,000 $ 60,000 $100,000 40,000 80,000 20,000 60,000 (10,000) 30,000 (20,000) 20,000 $ 90,000 $290,000 (Continued) NM

Answer 1

	Investment	Year	Income from Operations	Net CFs	Cumulative CFs	Payback Period	ARoR
Proposal A	$              450,000	1	$                 30,000	$      120,000	$          120,000		Average profit/Investment
		2	$                      30,000	$      120,000	$          240,000		(60000/5)/450000
		3	$                      20,000	$      110,000	$          350,000
		4	$                      10,000	$      100,000	$          450,000
		5	$                    (30,000)	$         60,000
			$                      60,000	$      510,000		4 years	2.67%
Proposal B	$              200,000	1	$                      60,000	$      100,000	$          100,000
		2	$                      40,000	$         80,000	$          180,000	=2 years + (200000-180000)/60000 *12
		3	$                      20,000	$         60,000	$          240,000
		4	$                    (10,000)	$         30,000
		5	$                    (20,000)	$         20,000
			$                      90,000	$      290,000		2 years, 4 months	9.00%
Proposal C	$              320,000	1	$                      36,000	$      100,000	$          100,000
		2	$                      26,000	$         90,000	$          190,000
		3	$                      26,000	$         90,000	$          280,000	=3 years+40000/80000*12
		4	$                      16,000	$         80,000	$          360,000
		5	$                      16,000	$         80,000
			$                   120,000	$      440,000		3 years, 6 months	7.50%
Proposal D	$              540,000	1	$                      92,000	$      200,000	$          200,000
		2	$                      72,000	$      180,000	$          380,000
		3	$                      52,000	$      160,000	$          540,000
		4	$                      12,000	$      120,000
		5	$                       (8,000)	$      100,000
			$                   220,000	$      760,000		3 years	8.15%

INote : Income from Operations were given effect to depreciation for each proposal already.

Proposal	Payback period (max 3 years)	Average Rate of return (>12%)	Accept for further analysis	Reject
A	4 years	2.67%		r
B	2 years, 4 months	9.00%	a
C	3 years, 6 months	7.50%		r
D	3 years	8.15%	a

Calculation of NPV

	Net CFs					PV of cash flows
Year	Proposal A	Proposal B	Proposal C	Proposal D	PVF @ 12%	Proposal A	Proposal B	Proposal C	Proposal D
1	$ 120,000	$ 100,000	$ 100,000	$ 200,000	0.8929	$       107,143	$         89,286	$         89,286	$       178,571
2	$ 120,000	$    80,000	$    90,000	$ 180,000	0.7972	$         95,663	$         63,776	$         71,747	$       143,495
3	$ 110,000	$    60,000	$    90,000	$ 160,000	0.7118	$         78,296	$         42,707	$         64,060	$       113,885
4	$ 100,000	$    30,000	$    80,000	$ 120,000	0.6355	$         63,552	$         19,066	$         50,841	$         76,262
5	$    60,000	$    20,000	$    80,000	$ 100,000	0.5674	$         34,046	$         11,349	$         45,394	$         56,743
	$ 510,000	$ 290,000	$ 440,000	$ 760,000		$      378,699	$      226,182	$      321,329	$      568,956
					Less : Investment	$       450,000	$      200,000	$      320,000	$       540,000
					NPV	$       (71,301)	$         26,182	$           1,329	$         28,956
					PV Index/Profitability index
					(PV of CFs/Investment)	$             0.84	$             1.13	$             1.00	$             1.05

Ranking :

	NPV	Ranking	PV Index/Profitability index	Ranking
Proposal A	$                        (71,301)	4	0.84	4
Proposal B	$                          26,182	2	1.13	1
Proposal C	$                            1,329	3	1.00	3
Proposal D	$                          28,956	1	1.05	2

Note: Rank 1 - Most Attractive
Rank 4 - Least attractive

8. NPV ranks proposal 4 as most attractive while PV index ranks proposal 2 as most attractive. NPV measures only the profitability of a proposed project/investment. Also, more NPV does not necessarily mean the return on investment is good. Ranking on the basis of more surplus or less surplus without taking into account the amount of investment that goes into the project, is flawed during capital rationing which is why we calculate Profitability index that measures the PV of benefits for every dollar of investment. Therefore, the company should invest its limited capital based on the PI ranking of every proposal.