Question

Net Present Value Method, 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		$890,159		$542,860		$263,813
Annual net cash flows:
	Year 1	369,000		258,000		159,000
	Year 2	343,000		232,000		110,000
	Year 3	314,000		206,000		80,000

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 10%, 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   has the largest present value index. Although   has the largest net present value, it returns less present value per dollar invested than does the  , as revealed by the present value indexes. The present value index for the   is less than 1, indicating that it does not meet the minimum rate of return standard.

Answer 1

Solution 1:

Computation of NPV
			Maintenance equipment		Ramp Facilities		Computer network
Particulars	Period	PV Factor	Amount	Present Value	Amount	Present Value	Amount	Present Value
Cash outflows:
Initial investment	0	1	$890,159.00	$890,159	$542,860.00	$542,860	$263,813.00	$263,813
Present Value of Cash outflows (A)				$890,159		$542,860		$263,813
Cash Inflows
Year 1	1	0.909	$369,000.00	$335,421	$258,000.00	$234,522	$159,000.00	$144,531
Year 2	2	0.826	$343,000.00	$283,318	$232,000.00	$191,632	$110,000.00	$90,860
Year 3	3	0.751	$314,000.00	$235,814	$206,000.00	$154,706	$80,000.00	$60,080
Present Value of Cash Inflows (B)				$854,553		$580,860		$295,471
Net Present Value (NPV) (B-A)				-$35,606		$38,000		$31,658
Profitability index (NPV / Initial investment)				-0.04		0.07		0.12

Solution 2:

Particulars	Initial investment	PV of cash inflows	Present Value Index
Maintenance Equipment	$890,159.00	$854,553.00	0.96
Ramp Facilities	$542,860.00	$580,860.00	1.07
Computer Network	$263,813.00	$295,471.00	1.12

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