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 $4,200,000 investment in equipment with a useful life of five years and no salvage value. Holston Company's discount rate is 18%. The project would provide net operating income each year for five years as follows: $3,600,000 1,550,000 2,050,000 Sales Variable expenses Contribution margin Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs Depreciation Total fixed expenses Net operating income $ 700,000 840,000 1,540,000 $ 510,000 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? Complete this question by entering your answers in the tabs below. Reg 1 Req 2 Rega Req 3A Req 3A Req 3B Compute the project's net present value. (Round your final answer to the nearest whole dollar amount.) Net present value < Reg1 Req 2 >

Answer 1

(1). Project’s Net Present Value

Annual Cash flow = Net Operating Income + Depreciation

= $510,000 + $840,000

= $1,350,000

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $1,350,000(PVIFA 18%, 5 Years) - $4,200,000

= [$1,350,000 x 3.127] - $4,200,000

= $4,221,450 - $4,200,000

= $21,450

“The Net Present Value (NPV) will be $21,450”

(2)-Project’s simple rate of return

Simple rate of Return = [Net Operating Income / Investment] x 100

= [$510,000 / $4,200,000] x 100

= 12.14%

“The Project’s simple rate of return will be 12.14%”

(3)(a)-Would the company want Derrick to pursue this investment opportunity – YES

(3)(b)-Would Derrick be inclined to pursue this investment opportunity – NO

NOTE

The formula for calculating the Present Value Annuity Inflow Factor (PVIFA) is [{1 - (1 / (1 + r)n} / r], where “r” is the Discount Rate/Cost of capital and “n” is the number of years.