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 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 Brewer_8e_Rechecks_2020_01_30 Click here to view Exhibit 12B-1 and Exhibit 12B-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? 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

First we compute the income statement:

Sales	5,000,000
Variable Costs	2,240,000
Contribution	2,760,000
Fixed Costs
Advertising,etc	860,000
Depreciation	1,124,000.00
Net operating income	776,000

1. NPV:

So, Net operating income	776,000.00
Add: Depreciation	1,124,000.00
Cash Inflows	1,900,000.00
Discount Factor for 5 years @ 19%	3.057
Discounted Cash Inflows+	5,808,300.00
Less: Initial Capital Outlay	5,620,000.00
NPV	188,300.00

2. IRR:

We can use either excel or compute manually,

In excel we use the formula '=IRR(Values,guess)' we get the answer as 21%

Manually, we first compute NPV of the project for 23% =>

Cash Inflows	1,900,000.00
Discount Factor for 5 years @ 23%	2.803
Discounted Cash Inflows+	5,326,599.00
Less: Initial Capital Outlay	5,620,000.00
NPV	-293401

IRR = Lower Rate + [ (NPV lower rate) / (NPV Lower rate - NPV Higher rate) * (Higher rate - Lower rate)

ie., IRR = 19 + [(188300)/ (188300- (-293401))*(23-19)] = 20.6% or 21%

3. Project’s simple rate of return = Net Operating Income / Initial Outlay * 100

=>776000 / 5620000 * 100 =13.8%

4a. Since the NPV is positive, Casey can pursue this opportunity. So answer is Yes.

4b. Since existing division's ROI is 23%, at this discount rate, NPV would go negative. Hence, Casey would not be inclined to pursue this investment opportunity.

Pls comment in case of any query regarding the solution.