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Accounting

27th Edition
WARREN + 5 others
ISBN: 9781337272094

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Section
BuyFindarrow_forward

Accounting

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

Capital rationing decision for a service company involving 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:

  Investment Year Income from Operations Net Cash Flow
Proposal A: $450,000 1 $ 30,000 $120,000
    2 30,000 120,000
    3 20,000 110,000
    4 10,000 100,000
    5 (30,000) 60,000
      $ 60,000 $510,000
Proposal B: $200,000 1 $ 60,000 $100,000
    2 40,000 80,000
    3 20,000 60,000
    4 (10,000) 30,000
    5 (20,000) 20,000
      $ 90,000 $290,000
Proposal C: $320,000 1 $ 36,000 $100,000
    2 26,000 90,000
    3 26,000 90,000
    4 16,000 80,000
    5 16,000 80,000
      $120,000 $440,000
Proposal D: $540,000 1 $ 92,000 $200,000
    2 72,000 180,000
    3 52,000 160,000
    4 12,000 120,000
    5 (8,000) 100,000
      $220,000 $760,000

 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.

  Instructions

  1. 1. Compute the cash payback period for each of the four proposals.
  2. 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. Round to one decimal place.
  3. 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 by placing a check mark in the appropriate column to the right, indicate which proposals should lie accepted for further analysis and which should be rejected.
Proposal Cash Payback Period

Average Rate

of Return

Accept for Further Analysis Reject
A        
E        
C        
D        

 4.    For the proposals accepted for further analysis in part (3), compute the net present value. Use a rate of 12% and the present value of $1 table appearing in this chapter (Exhibit 2).

 5.    Compute the present value index for each of the proposals in part (4). Round to two decimal places.

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

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

 8.    Based on the analyses, comment on the relative attractiveness of the proposals ranked in parts (6) and (7).

1.

To determine

Cash payback method:

Cash payback period is the expected time period which is required to recover the cost of investment. It is one of the capital investment method used by the management to evaluate the long-term investment (fixed assets) of the business.

Average rate of return method:

Average rate of return is the amount of income which is earned over the life of the investment. It is used to measure the average income as a percent of the average investment of the business, and it is also known as the accounting rate of return.

The average rate of return is computed as follows:

Average rate of return =Estimated average annual incomeAverage investment

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 desired by the business based on the net income from the investment, and it is also called as the discounted cash flow method.

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 determine: The cash payback period for the given proposals.

Explanation

The cash payback period for the given proposals is as follows:

Proposal A:

Initial investment=$450,000

Cash payback period of Proposal A
 Year  Net cash flows  Cumulative net cash flows
            1     120,000         120,000
            2     120,000         240,000
            3     110,000         350,000
            4     100,000         450,000

Table (1)

Hence, the cash payback period of proposal A is 4 years.

Proposal B:

Initial investment=$200,000

Cash payback period of Proposal B
Year Net cash flows Cumulative net cash flows
                  1        100,000       100,000
                  2          80,000       180,000
4 months (1)          20,000       200,000

Table (2)

Hence, the cash payback period of proposal B is 2 years and 4 months.

Working note:

1. Calculate the no. of months in the cash payback period:

No. of months = (Balance amount of intital investmentTotal cash flow for particular year)×No

2.

To determine
The average rate of return for the give proposals.

3.

To determine

To indicate: The proposals which should be accepted for further analysis, and which should be rejected.

4.

To determine
The net present value of preferred proposals.

5.

To determine

To determine:  The present value index for each proposal.

6.

To determine

To rank: The proposal from most attractive to least attractive, based on the present value of net cash flows.

7.

To determine

To rank: The proposal from most attractive to least attractive, based on the present value of index.

8.

To determine

To analysis: The proposal which is favor to investment, and comment on the relative attractiveness of the proposals based on the rank.

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