Question

Exercise 14-9 (Algo) Net Present Value Analysis and Simple Rate of Return [LO14-2, LO14-6]

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 $3,700,000 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:

 

Sales			$	3,100,000
Variable expenses				1,300,000
Contribution margin				1,800,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	660,000
Depreciation		740,000
Total fixed expenses				1,400,000
Net operating income			$	400,000

 

Click here to view Exhibit 14B-1 and Exhibit 14B-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?

 

Next

Answer 1

1	NPV	Year	Cash Flow	PV @16%	Present Value
	Initial Cost	0	-37,00,000	1	-37,00,000
	Inflow after adding depreciation (4,00,000+7,40,000)	1-5 Y	11,40,000	3.274	37,32,360
	Net Present Value				32,360
2	Simple Rate of Return
	Simple Rate of Return = (Net Profit/Investment)
	Simple Rate of Return = (4,00,000/37,00,000)
	Simple Rate of Return = 10.81%
3a	YES
	The Net Present Value is Positive
	So they should pursue this investment opportunity.
3b	NO
	ROI is 20% but the Simple Rate of Return is 10.81%
	Here Simple rate of return is less than ROI
	So not recommended to accept investment.