Question

Derrick Iverson is a divisional manager for Holston Company. His annual pay raises are largely determined by his division’s return on investment (ROI), which has been above 20% each of the last three years. Derrick is considering a capital budgeting project that would require a $4,120,000 investment in equipment with a useful life of five years and no salvage value. Holston Company’s discount rate is 17%. The project would provide net operating income each year for five years as follows: Sales $ 3,500,000 Variable expenses 1,500,000 Contribution margin 2,000,000 Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs $ 690,000 Depreciation 824,000 Total fixed expenses 1,514,000 Net operating income $ 486,000 Click here to view Exhibit 12B-1 and Exhibit 12B-2, to determine the appropriate discount factor(s) using tables. Required: 1. Compute the project's net present value. 2. Compute the project's simple rate of return. 3a. Would the company want Derrick to pursue this investment opportunity? 3b. Would Derrick be inclined to pursue this investment opportunity?

Answer 1

Answer is given below

1 Project's NPV Net Operating Income Depreciation Annual Cash inflow PV factor 17% for 5 years $486,000 $824,000 $1,310,000 3.1993 Present value of Cash inflows Initial investment Net present value $4,191,143 $4,120,000 $71,143 2 Simple rate of return Net Operating Income Initial Investment $486,000 $4,120,000 11.8% 3 a) Company may want Derrick Iverson to pursue the opportunity since NPV is positive b) Derrick Iverson may not be inclined to purse the opportunity since his historical returns has been above 20% for each of the past 3 years and this Project simple return is 11.8%