Question

Casey Nelson is a divisional manager or Pigeon Company is annual pay raises are largely determined by his division's return on investment ROI), which has been above 23% each of the last three years. Casey is considering a capital budgeting project that would require a $5,380,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company's discount rate is 19%. The project would provide net operating income each year for five years as follows: Sales Variable expenses Contribution margin Fixed expenses: S 4,800,000 2,160,000 2,640,000 Advertising, salaries, and other fixed out-of-pocket costs $ 840,000 1,076,000 Total fixed expenses 1,916,000 S 724,000 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. 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

Net operating income	724000
Add: Depreciation	1076000
Net cash flows	1800000
1
	Now	Year 1	Year 2	Year 3	Year 4	Year 5
Investment cost	-5380000
Net cash flows		1800000	1800000	1800000	1800000	1800000
Total cash flows	-5380000	1800000	1800000	1800000	1800000	1800000
PV factor @ 19%	1	0.840	0.706	0.593	0.499	0.419
Present value of cash flows	-5380000	1512000	1270800	1067400	898200	754200
Net present value	122600
2
PV factor internal rate of return=5380000/1800000 = 2.989
The PV factor 2.989 for 5 years is closest to 20%
Internal rate of return = 20%
3
Simple rate of return = Net operating income/Investment cost
Simple rate of return = 724000/5380000= 13.5%
4a
Yes, the company would want Casey to pursue this investment as Net Present value is positive
4b
No, Casey would not be inclined to pursue this investment as as his ROI will decrease