Question

Net Present Value Method, An index computed by dividing the total present value of the net cash flow to be received from a proposed capital investment by the amount to be invested.Present Value Index, and Analysis for a service company

Continental Railroad Company is evaluating three capital investment proposals by using the net present value method. Relevant data related to the proposals are summarized as follows:

Maintenance

Equipment Ramp

Facilities

Computer

Network

Amount to be invested $584,896 $335,577 $171,714

Annual net cash flows:

Year 1 251,000 168,000 105,000

Year 2 233,000 151,000 72,000

Year 3 213,000 134,000 53,000

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. Assuming that the desired rate of return is 12%, prepare a net present value analysis for each proposal. Use the present value of $1 table above. If required, use the minus sign to indicate a negative net present value. If required, round to the nearest dollar.

Maintenance Equipment Ramp Facilities Computer Network

Total present value of net cash flow $ $ $

Amount to be invested

Net present value $ $ $

2. Determine a present value index for each proposal. If required, round your answers to two decimal places.

Present Value Index

Maintenance Equipment

Ramp Facilities

Computer Network

3. The

maintenance equipment

ramp facilities

computer network

has the largest present value index. Although

maintenance equipment

ramp facilities

computer network

has the largest net present value, it returns less present value per dollar invested than does the

maintenance equipment

ramp facilities

computer network

, as revealed by the present value indexes. The present value index for the

maintenance equipment

ramp facilities

computer network

is less than 1, indicating that it does not meet the minimum rate of return standard.

Answer 1

Answer 1.

Rate of Return = 12%

Maintenance Equipment:

Present Value of Cash Inflows = $251,000 * PV of $1 (12%, 1) + $233,000 * PV of $1 (12%, 2) + $213,000 * PV of $1 (12%, 2)
Present Value of Cash Inflows = $251,000 * 0.893 + $233,000 * 0.797 + $213,000 * 0.712
Present Value of Cash Inflows = $561,500

Net Present Value = Present Value of Cash Inflows - Amount to be Invested
Net Present Value = $561,500 - $584,896
Net Present Value = -$23,396

Ramp Facilities:

Present Value of Cash Inflows = $168,000 * PV of $1 (12%, 1) + $151,000 * PV of $1 (12%, 2) + $134,000 * PV of $1 (12%, 2)
Present Value of Cash Inflows = $168,000 * 0.893 + $151,000 * 0.797 + $134,000 * 0.712
Present Value of Cash Inflows = $365,779

Net Present Value = Present Value of Cash Inflows - Amount to be Invested
Net Present Value = $365,779 - $335,577
Net Present Value = $30,202

Computer Network:

Present Value of Cash Inflows = $105,000 * PV of $1 (12%, 1) + $72,000 * PV of $1 (12%, 2) + $53,000 * PV of $1 (12%, 2)
Present Value of Cash Inflows = $105,000 * 0.893 + $72,000 * 0.797 + $53,000 * 0.712
Present Value of Cash Inflows = $188,885

Net Present Value = Present Value of Cash Inflows - Amount to be Invested
Net Present Value = $188,885 - $171,714
Net Present Value = $17,171

Answer 2.

Maintenance Equipment:

Present Value Index = Present Value of Cash Inflows / Initial Investment
Present Value Index = $561,500 / $584,896
Present Value Index = 0.96

Ramp Facilities:

Present Value Index = Present Value of Cash Inflows / Initial Investment
Present Value Index = $365,779 / $335,577
Present Value Index = 1.09

Computer Network:

Present Value Index = Present Value of Cash Inflows / Initial Investment
Present Value Index = $188,885 / $171,714
Present Value Index = 1.10

Answer 3.

The computer network has the largest present value index. Although ramp facilities has the largest net present value, it returns less present value per dollar invested than does the computer network, as revealed by the present value indexes. The present value index for the maintenance equipment is less than 1, indicating that it does not meet the minimum rate of return standard.