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 24% each of the last three years. Casey is considering a capital budgeting project that would require a $5,850,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company’s discount rate is 20%. The project would provide net operating income each year for five years as follows:

Sales			$	5,200,000
Variable expenses				2,320,000
Contribution margin				2,880,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	880,000
Depreciation		1,170,000
Total fixed expenses				2,050,000
Net operating income			$	830,000

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

1.

1. Calculation of project's NPV
Year	Income	PVF @ 20%	PVCF
1	2,000,000	0.83	1,660,000
2	2,000,000	0.69	1,380,000
3	2,000,000	0.575	1,150,000
4	2,000,000	0.48	960,000
5	2,000,000	0.4	800,000
		PVCF	5,950,000
		Investment	5,850,000
		NPV	100,000

2. Calculation of project's IRR
Year	Income	PVF @ 20%	PVCF
1	2,000,000	0.83	1,660,000
2	2,000,000	0.69	1,380,000
3	2,000,000	0.575	1,150,000
4	2,000,000	0.48	960,000
5	2,000,000	0.4	800,000
		PVCF	5,950,000
		Investment	5,850,000
		NPV	100,000
Year	Income	PVF @ 21.5%	PVCF
1	2,000,000	0.82	1646090.535
2	2,000,000	0.68	1354807.025
3	2,000,000	0.56	1115067.51
4	2,000,000	0.46	917751.0371
5	2,000,000	0.38	755350.6478
		PVCF	5,789,067
		Investment	5,850,000
		NPV	-60,933

IRR = Lower rate of interest + [NPV at higher value x (Higher rate - lower rate)/difference in NPV]

=20% + [100,000 x (21.5-20)/(100000 + 60933)]

= 20.93%

3. Simple rate of return = Total income/Total investment

=[(830000*5)/5,850,000] / 5 years

=14.18%

4-a. Since the NPV is positive as shown in 1, company would want Casey to take this oppurtunity.

4-b. No, Casey would not be inclined towards taking the oppurtunity as it would reduce its division's return as it is above the NPV of 20.93%. This would result in lowering of his pay. Therefore, he would not be inclined to take the oppurtunity.