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 %

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

%

B

%

C

%

D

%

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.

Select the proposal accepted for further analysis.

Present value of net cash flow total $ $

Less 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.

Present value index (rounded)

6. Rank the proposals from most attractive to least attractive, based on the present values of net cash flows computed in part (4).

Rank 1st

Rank 2nd

7. Rank the proposals from most attractive to least attractive, based on the present value indexes computed in part (5).

Rank 1st

Rank 2nd

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.

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