Question

Net Present Value Analysis; Simple Rate of Return [L011-2, L0114] Consider the following situation, you are a division manager for Poole Inc. Your annual pay raises are based on your division's return on investment (ROI), which has averaged 20% each of the last three years. You have been presented with a possible capital budgeting project that would require a $3,600,000 investment in equipment with a useful life of five years and no salvage value. Poole Inc has a discount rate of 16% The project would provide net operating income each year for five years as follows $ 3,500,000 1,640,000 1,860,000 Sales Variable expenses Contribution margin Fixed expenses 9 Advertising, salaries, and other fixed out of-pocket costs Depreciation 710,000 720,000 Total fixed expenses Net operating income 1,430,000 12 430,000 13 15 16 17 Required: 1 What is the project's NPV? 20 22 What is the project's simple rate of return? 23 25 26 27 3 Taking into consideration the project's NPV, would the company want you to pursue this investment opportunity? Why? 28 29 4 Taking into consideration your average ROl and the project's simple rate of return, would you want pursue this investment 30 opportunity? Why?

Answer 1

Initial Investment = $3,600,000
Life of Project = 5 years

Annual Net Cash flows = Annual Net Operating Income + Depreciation
Annual Net Cash flows = $430,000 + $720,000
Annual Net Cash flows = $1,150,000

Answer 1.

Discount Rate = 16%

Net Present Value = -$3,600,000 + $1,150,000 * PVA of $1 (16%, 5)
Net Present Value = -$3,600,000 + $1,150,000 * 3.27429
Net Present Value = $165,433.50

Answer 2.

Simple Rate of Return = Annual Net Income / Initial Investment
Simple Rate of Return = $430,000 / $3,600,000
Simple Rate of Return = 11.94%

Answer 3.

NPV of this project is positive. So, the company should purse this investment.

Answer 4.

Average ROI is higher than the simple rate of return. So, the company should not purse this investment.