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: Line Item Description 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 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 20%, 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. Line Item Description Maintenance Equipment Ramp Facilities Computer Network Total present value of net cash flow $fill in the blank 1 $fill in the blank 2 $fill in the blank 3 Less amount to be invested fill in the blank 4 fill in the blank 5 fill in the blank 6 Net present value $fill in the blank 7 $fill in the blank 8 $fill in the blank 9 2. Determine a present value index for each proposal. If required, round your answers to two decimal places. Line Item Description Present Value Index Maintenance Equipment fill in the blank 10 Ramp Facilities fill in the blank 11 Computer Network fill in the blank 12 3. The fill in the blank 1 of 4 has the largest present value index. Although fill in the blank 2 of 4 has the largest net present value, it returns less present value per dollar invested than does the fill in the blank 3 of 4 , as revealed by the present value indexes. The present value index for the fill in the blank 4 of 4 is less than 1, indicating that it does not meet the minimum rate of return standard.
Net Present Value
Net present value is the most important concept of finance. It is used to evaluate the investment and financing decisions that involve cash flows occurring over multiple periods. The difference between the present value of cash inflow and cash outflow is termed as net present value (NPV). It is used for capital budgeting and investment planning. It is also used to compare similar investment alternatives.
Investment Decision
The term investment refers to allocating money with the intention of getting positive returns in the future period. For example, an asset would be acquired with the motive of generating income by selling the asset when there is a price increase.
Factors That Complicate Capital Investment Analysis
Capital investment analysis is a way of the budgeting process that companies and the government use to evaluate the profitability of the investment that has been done for the long term. This can include the evaluation of fixed assets such as machinery, equipment, etc.
Capital Budgeting
Capital budgeting is a decision-making process whereby long-term investments is evaluated and selected based on whether such investment is worth pursuing in future or not. It plays an important role in financial decision-making as it impacts the profitability of the business in the long term. The benefits of capital budgeting may be in the form of increased revenue or reduction in cost. The capital budgeting decisions include replacing or rebuilding of the fixed assets, addition of an asset. These long-term investment decisions involve a large number of funds and are irreversible because the market for the second-hand asset may be difficult to find and will have an effect over long-time spam. A right decision can yield favorable returns on the other hand a wrong decision may have an effect on the sustainability of the firm. Capital budgeting helps businesses to understand risks that are involved in undertaking capital investment. It also enables them to choose the option which generates the best return by applying the various capital budgeting techniques.
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:
| Line Item Description | 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 |
| 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
| Line Item Description | Maintenance Equipment | Ramp Facilities | Computer Network |
|---|---|---|---|
| Total present value of net cash flow | $fill in the blank 1 | $fill in the blank 2 | $fill in the blank 3 |
| Less amount to be invested | fill in the blank 4 | fill in the blank 5 | fill in the blank 6 |
| Net present value | $fill in the blank 7 | $fill in the blank 8 | $fill in the blank 9 |
2. Determine a present value index for each proposal. If required, round your answers to two decimal places.
| Line Item Description | Present Value Index |
|---|---|
| Maintenance Equipment | fill in the blank 10 |
| Ramp Facilities | fill in the blank 11 |
| Computer Network | fill in the blank 12 |
3. The fill in the blank 1 of 4
has the largest present value index. Although fill in the blank 2 of 4
has the largest net present value, it returns less present value per dollar invested than does the fill in the blank 3 of 4
, as revealed by the present value indexes. The present value index for the fill in the blank 4 of 4
is less than 1, indicating that it does not meet the minimum rate of return standard.
NPV is defined as the sum of the present values of all future cash inflows less the sum of the present values of all cash outflows associated with the project.
Variables in the question:
| Description | Maintenance Equipment | Ramp Facilities | Computer Network |
| Amount to be invested ($) | 8000000 | 20000000 | 9000000 |
| Annual net cash flow | |||
| Year 1 ($) | 4000000 | 12000000 | 6000000 |
| Year 2 ($) | 3500000 | 10000000 | 5000000 |
| Year 3 ($) | 2500000 | 9000000 | 4000000 |
Desired rate of return is 20%
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