The Management of Ortega Manufactring has three different proposals under consid

Question

The Management of Ortega Manufactring has three different proposals under consideration. The Accounting Department has prepared the above information:

1-Which of the above proposals generates the greatest annual cash flow? a) proposal A b) proposal B c) proposal C d) cannot be determined with the given information

2-The above data indicate that:

a) After considering the timing of future cash flows, each of the three proposals is expected to provide a rate of return in excess of 15%

b) Proposal A will generate net losses annually

c) If the salvage value of proposal A were $52,000 instead of zero, proposal A would have the highest net present value

d) The present value of proposal B's future cash flows is $2,471,600

3-On the basis of the above data, which of the following is FALSE?

a) Proposal A should be considered unacceptable

b) Proposal C is the best alternative because it has the shortest payback period, which is the most meaningful of the capital budgting statistics

c) Proposal A's negative net present value indicates that this alternative will not generate management's required rate of return

d) Although proposals B and C are each acceptable, proposal B is a better investment considering the time value of money

b A B C Initial Investment $3,100,000 $2,450,000 $2,055,000 Useful life of equipment 7 years 7 years 7 years Estimated salvage value $0 $400,000 $100,000 Payback period 4.2 years 4.4 years 4 years Net present value discount at 15% ($30,000) $21,600 $15,800

Explanation / Answer

Answer 1

Proposal A has the highest annual cash flow becuase it has the highest initial investment and the secod lowest payback period. Under proposal A, the company will be able to recover its initial investment of $310000 in 4.2 years whereas the other two proposals though having lower initial investment take almost the same time to recover the investment. hence, it can be said that proposal A has the highest annual cash flows.

Answer 2

D. The present value of Proposal B's future cash flow is $2,471,600.

This can be shown as under:

NPV = Present value of cash flows - initial investment

applying the above formula for proposal B:

$21600 = Present value of cash flows - $2,450,000

Hence, Present value of cash flows = $2,471,600

Answer C

b)  Proposal C is the best alternative because it has the shortest payback period, which is the most meaningful of the capital budgting statistics

This is becuase under capital budgeting, the most meaningful and preferable technique is NPV. If the NPV of a project is positive, then it is considered as an acceptable investment. NPV is always preffered over other capital budgeting techniques. Under the above situation, though Proposal C has the lowest payback period but proposal B has the highest NPV, hence, the company should go ahead with Proposal B.

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