Question

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 $4,140,000 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 $ 3,400,000 Variable expenses 1,450,000 Contribution margin 1,950,000 Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs $670,000 Depreciation 670,000 Total fixed expenses 1,340,000 Net operating income $ 610,000 Click here to view Exhibit 11B-1 and Exhibit 11B-2, to determine the appropriate discount factor(s) using tables. Required:

1. Compute the project's net present value. (Use the appropriate table to determine the discount factor(s), intermediate calculations and final answer to the nearest dollar amount.)

2. Compute the project's simple rate of return. (Round your answer to 1 decimal place. i.e. 0.123 should be considered as 12.3%.)

3-a. Would the company want Derrick to pursue this investment opportunity?

Yes

No

3-b. Would Derrick be inclined to pursue this investment opportunity?

Yes

No

Answer 1

Solution 1:

Annual net Cash Inflow
Net Operating Income	$6,10,000
Add: Depreciation	$6,70,000
Net Cash Flow	$12,80,000

	Chart Values are based on
	n=	5
	i=	16%
Cash Flow	Select Chart	Amount	*	PV Factor	=	Present Value
Annual Net cash Inflow	Present Value of an annuity of 1	$12,80,000		3.274	=	$41,90,720
	Present value of cash inflows					$41,90,720
	Present value of cash outflows					-$41,40,000
	Net Present Value					$50,720

Solution 2:

Simple rate of Return
Choose Numerator	/	Choose Denominator	=	Accounting Rate of Return
Annual Net operating Income	/	Initial Investment	=	Accounting Rate of Return
$6,10,000	/	$41,40,000	=	14.7%

Solution 3-a:

No, The company would not want Derrick to pursue this investment opportunity because Simple rate of return (14.7%) is less than company's discount rate (16%)

Solution 3-b:

No, Derrick would not want to pursue this investment opportunity because Simple rate of return (14.7%) is less than division’s expected return on investment (20%)