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 $3,000,000 investment in equipment with a useful life of five years and no salvage value. Holston Company's discount rate is 15%. The project would provide net operating income each year for five years as follows: $2,500,000 1,000,000 1,500,000 Sales Variable expenses Contribution margin Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs Depreciation Total fixed expenses Net operating income $ 600,000 600,000 1,200,000 $ 300,000 Click here to view Exhibit 13B-1 and Exhibit 13B-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? Complete this question by entering your answers in the tabs below.

Answer 1

NPV is difference between initial outlay and present value of cash flow.Discount factors are used to find present value.

Net income	$300,000
Add: Depreciation (Non cash expense)	$600,000
Cash flow	$900,000 ($300,000+$600,000)
PV Factor (15% for 5 years) (1/1.15)^1+(1/1.15)^2+(1/1.15)^3+(1/1.15)^4+(1/1.15)^5	3.352
Annual cash flow	$3,016,800($900,000*3.352)
Less: initial outlay	($3,000,000)
Net Present Value	$16,800

NPV is $16,800

(2) Simple rate of return

(Annual net operating income/Initial investment)*100

=($300,000/$3,000,000)*100

=10%

(3)

YES, as the NPV of an investment is positive management will be inclined to accept the project.

(4) NO

As divisional manager's increase in pay is dependent on ROI which is 20% or higher , Derrick would not be interested in this opportunity as its ROI is 10% i.e < 20%. his pay wont increase.