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Accounting

27th Edition
WARREN + 5 others
ISBN: 9781337272094

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BuyFindarrow_forward

Accounting

27th Edition
WARREN + 5 others
ISBN: 9781337272094
Textbook Problem

Net present value method, present value index, and analysis

 Continental Railroad Company is evaluating three capital investment proposals 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 $8,000,000 $20,000,000 $9,000,000
Annual net cash flows:      
Year 1 4,000,000 12,000,000 6,000,000
Year 2 3,500,000 10,000,000 5,000,000
Year 3 2,500,000 9,000,000 4,000,000

Instructions

  1. 1. Assuming that the desired rate of return is 20%, prepare a net present value analysis for each proposal. Use the present value of $1 table appearing in this chapter (Exhibit 2).
  2. 2. Determine a present value index for each proposal. Round to two decimal places.
  3. 3. Which proposal offers the largest amount of present value per dollar of investment? Explain.

1.

To determine

Net present value method:

Net present value method is the method which is used to compare the initial cash outflow of investment with the present value of its cash inflows. In the net present value, the interest rate is determined by the business, based on the net income from the investment, and it is also called as the discounted cash flow method.

To determine: The net present value of each investment, using the present value of $1 table in Exhibit 2.

Explanation

Calculation of the net present value of three projects is as follows:

2.

To determine

Present value index:

Present value index is a technique, which is used to rank the proposals of the business.  It is used by the management when the business has more investment proposals, and limited fund.

The present value index is computed as follows:

Present value index =Total present value of net cash flowAmount to be invested

To calculate: The present value index of the investment proposals.

3.

To determine

To explain: The proposal that offers the largest amount of present value per dollar of investment.

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