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 $4,450,000 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:

Sales			$	3,800,000
Variable expenses				1,650,000
Contribution margin				2,150,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	710,000
Depreciation		890,000
Total fixed expenses				1,600,000
Net operating income			$	550,000

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

Ans 1.
Computation of Net Present Value of the Project
Cash Inflow of each year-
Sales	3100000
Less: Variable Expenses	1300000
Contribution	1800000
Fixed Expenses(Excluding Depreciation)	660000
Net Operating Income/Cash Inflow	1140000
Cash Outflow (A)	3700000
Cash Inflow	1140000
PVIAF(16%, 5years)	3.274
Present value of future Cash inflow(B)	3732360
Net Present Value(B)-(A)	32360
Ans.2
Computation of Project's simple rate of retun
Net Income	400000
Investment	3700000
Simple rate of Return	10.81%
Net Income/Investment*100
400000/3700000*100
Ans.3
The company want Derrick to pursue this opportunity because Project's NPV is Positive
this meanse the project is viable and gives a better return on investment.
Ans.4
As in the Questions says that Derrick's annual pay raises are largely dependent
by his Division's Return on Investment(ROI), which has been above 20% each of
the last three years.
In this project, Company's Return on investment will be 10.81%(as per ans.2),
which is below 20%, So Derrick would not be inclined to pursue this investment
oppurtunity.
Working Note:
1.   While calculating Cash inflow, Depreciation is not included because it is an
non cash expenses

2. NPV can be calculate alternatively as follows-

Years	Cash Flow	PVF @16%	Present Value of Cash Flow
0	-3700000	1	-3700000
1	1140000	0.862	982680
2	1140000	0.743	847020
3	1140000	0.641	730740
4	1140000	0.552	629280
5	1140000	0.476	542640
	NPV		32360