Question

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 22% each of the last three years. Casey is considering a capital budgeting project that would require a $3,900,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company’s discount rate is 18%. The project would provide net operating income each year for five years as follows:

Sales			$	3,800,000
Variable expenses				1,760,000
Contribution margin				2,040,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	740,000
Depreciation		780,000
Total fixed expenses				1,520,000
Net operating income			$	520,000

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?

Answer 1

Solution 1:

G H I Casey Nelson Annual net Cash Inflow Net Operating Income Add: Depreciation Net Cash Flow $520,000 $780,000 $1,300,000 8 10 12 13 14 Chart Values are based on nr 5 1 i= 18% Select Chart Amount * PV Factor = Present Value Present Value of an annuity of 1 $1,300,000 3.127 = $4,065,100 15 16 17 Cash Flow Annual Net cash Inflow 18 19 Present value of cash inflows Present value of cash outflows Net Present Value $4,065,100 $3,900,000 $165,100 23 24 25 26 27 28 29 0.847 0.718 0.609 0.516 0.437 3.127 30 31 32 33 34 35 36 37 38 39 40 41 44 46 47 48 49 -26 (21) Sheet616 (2) ) Sheet936 Sheet106 (19) Sheet383 (5)

Solution 2:

Q R S T U V W 12 13 Period IRR 14 15 1 2 Project A Cash flows $3,900,000 $1,300,000 $1,300,000 $1,300,000 $1,300,000 $1,300,000 20% 3 18 21 24 25 26 27 28 29 30 31 32 33 34 35 36 37 40 -26 (21) Sheet616 (2) ) Sheet936 Sheet106 (19) Sheet383 (5)

Solution 3:

NO Simple rate of Return Choose Numerator \/Choose Denominator = Simple Rate of Return Annual Net operating Income / Initial Investment = Simple Rate of Return $520,000/ $3,900,000= 13.3% 11 12 13 14 15 le 16 00 08888 21 22 23 47 24 18 27 37 28 27 29 30 31 32 33 34 35 36 37 38 39 40 -26 (21) Sheet616 (2) ) Sheet936 Sheet106 (19) Sheet383 (5)

Solution 4a:

Yes, the company would want Casey to pursue this investment opportunity as its IRR is more than discount rate.

Solution 4b:

No, Casey would not be inclined to pursue this investment opportunity as its Simple rate of return is much less than division's ROI.