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 $6,100,000 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: $ 5,400,000 2,400,000 3,000,000 Sales Variable expenses Contribution margin Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs Depreciation Total fixed expenses Net operating income $ 900,000 1,220,000 2,120,000 880,000 $ Click here to view Exhibit 7B-1 and Exhibit 7B-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)
Net Operating Cash Flow = $880,000 + $1,220,000	$   2,100,000.00
Present value of annual Net operating Cash Flow = $2,100,000 x PVA(20%,5)	$6,280,285.49
Less: Initial Investment	$ (6,100,000.00)
NPV	$180,285
2)
Year	Cash Flow
0	$ (6,100,000.00)
1	$   2,100,000.00
2	$   2,100,000.00
3	$   2,100,000.00
4	$   2,100,000.00
5	$   2,100,000.00
IRR	21%
3)
Simple Rate of Return = Annual incremental net income/ Initial investment	14.4%
4) a & b
The company would want Casey to pursue the investment opportunity because it has a positive net present value of $180,285 However, Derrick might be inclined to reject the opportunity because its simple rate of return of 14.4% is well below his historical return on investment (ROI) of 24%. Casey may be justifiably concerned that implementing this project would lower his ROI and his next pay raise.