Casey Nelson is a divisional manager for Pigeon Company. His annual pay raises are largely determined by his division’s return on investment (ROI), which has been above 23% each of the last three years. Casey is considering a capital budgeting project that would require a $5,620,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company’s discount rate is 19%. The project would provide net operating income each year for five years as follows:
Sales | $ | 5,000,000 | ||
Variable expenses | 2,240,000 | |||
Contribution margin | 2,760,000 | |||
Fixed expenses: | ||||
Advertising, salaries, and other fixed out-of-pocket costs |
$ | 860,000 | ||
Depreciation | 1,124,000 | |||
Total fixed expenses | 1,984,000 | |||
Net operating income | $ | 776,000 | ||
Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using tables.
Required:
1. What is the project’s net present value?
2. What is the project’s internal rate of return to the nearest whole percent?
3. What is the project’s simple rate of return?
4-a. Would the company want Casey to pursue this investment opportunity?
4-b. Would Casey be inclined to pursue this investment opportunity?
1 | Net Present Value | = | $ 1,90,200 | ||
2 | IRR | = | 21% | ||
3 | Simple rate of return | = | 13.8% | ||
4 - a. | Yes | ||||
4 - b. | No | ||||
1 | |||||
Year | Value Flows | Present Factor @19% | Present Value | ||
Initial Cost | 0 | $ -56,20,000 | 1 | $ -56,20,000 | |
Cash Inflows ($1124000 + $776000) | 1 - 5 | $ 19,00,000 | 3.058 | $ 58,10,200 | |
Net Present Value | $ 1,90,200 | ||||
2 | Computation of IRR | ||||
Year | Value Flows | ||||
0 | $ -56,20,000 | ||||
1 | $ 19,00,000 | ||||
2 | $ 19,00,000 | ||||
3 | $ 19,00,000 | ||||
4 | $ 19,00,000 | ||||
5 | $ 19,00,000 | ||||
IRR | = | 21% | |||
3 | Computation of Simple rate of return: | ||||
Simple rate of return | = | Net Profit / Investment | |||
= | $776000 / $5620000 | ||||
= | 13.8% | ||||
4 - a. | Yes | ||||
As the Net Present value is positive it is beneficial for company. | |||||
4 - b. | No | ||||
ROI | = | 23% | |||
Simple rate of return | = | 13.8% | |||
As, ROI is more than Simple rate of return. It is not recommended to accept the Investment opportunity. | |||||
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