Question

Exercise 13-9 Net Present Value Analysis and Simple Rate of Return [LO13-2, LO13-6] 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 $4,000,000 investment in equipment with a useful life of five years and no salvage value. Holston Company's discount rate is 16%. The project would provide net operating income each year for five years as follows: $3,300,000 1,400,000 1,900,000 Sales Variable expenses Contribution margin Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs Depreciation Total fixed expenses $ 660,000 800,000 1,460,000 440,000 Net operating income 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?

Answer 1

Net operating income	440000
Add: Depreciation	800000
Net annual cash flows	1240000
1
	Year 1	Year 2	Year 3	Year 4	Year 5
Net annual cash flows	1240000	1240000	1240000	1240000	1240000
X PV factor @ 16%	0.862	0.743	0.641	0.552	0.476
Present value of Net annual cash flows	1068880	921320	794840	684480	590240
Total present value	4059760
Less: Investment cost	4000000
Net present value	59760
2
Simple rate of return = Net operating income/Investment cost
Simple rate of return = 440000/4000000= 11%
3a
Yes the company would want Derrick to pursue to this investment opportunity
3b
No, Derrick would not be inclined to pursue to this investment opportunity as his ROI will decrease