Question

WLC Company is a company in Franklin, WI. It is a merchandiser with multiple store locations. One of its store managers is considering a shift in her store’s product mix in anticipation of a strengthening economy. Her store would invest $800,000 in more expensive merchandise (an increase in its working capital) with the expectation that it would increase annual sales and variable expenses by $400,000 and $250,000, respectively for three years. At the end of the three-year period, the store manager believes that the economic surge will subside; therefore, she will release the additional investment in working capital. The store manager’s pay raises are largely determined by her store’s return on investment (ROI), which has exceeded 22% each of the last three years.

Click here to view Exhibit 13B-1 to determine the appropriate discount factor(s) using table.

Required:

1. Assuming the company’s discount rate is 16%, calculate the net present value of the store manager’s investment opportunity.

2. Calculate the annual margin, turnover, and return on investment (ROI) provided by the store manager’s investment opportunity.

3. Assuming that the company’s minimum required rate of return is 16%, calculate the residual income earned by the store manager’s investment opportunity for each of years 1 through 3.

4. Do you think the store manager would choose to pursue this investment opportunity? Do you think the company would want the store manager to pursue it?

Answer 1

Solution 1:

Computation of NPV - WLC Company
Particulars	Amount	Period	PV Factor	Present Value
Cash Outflows:
Initial Investment in working capital	$800,000	0	1	$800,000
Present Value of Cash Outflows (A)				$800,000
Cash Inflows:
Increase in annual contribution	$150,000	1-3	2.24589	$336,883
Release of working capital	$800,000	3	0.640658	$512,526
Present Value of Cash Inflows (B)				$849,410
Net Present Value (B-A)				$49,410

Solution 2:

Annual margin of store manager's investment opportunity = Additional Sales - Additional variable cost

= $400,000 - $250,000 = $150,000

Annual margin percentage = $150,000 / $400,000 = 37.50%

Turnvoer ratio = Sales / Investment = $400,000 / $800,000 = 0.50

ROI = Margin * Turnover = 37.50%*0.5 = 18.75%

Solution 3:

Minimum required return on investment opportunity = $800,000 * 16% = $128,000

Actual annual income from investment opportunity = $150,000

Residual Income for each year 1 to 3 = $150,000 - $128,000 = $22000

Solution 4:

As store manager pay raise determined by ROI which has exceeded 22% in last 3 years, if store manager will pursue this investment opportunity then store ROI will decrease beacuse ROI provided by new investment opportunity is only 18.75%. Therefore store manager would not pursue this investment opportunity.

As ROI provided by investment opportunity is higher than minimum required return of the company, therefore company want the store manager to pursue it.