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
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%)
Derrick Iverson is a divisional manager for Holston Company. His annual pay raises are largely determined...
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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 $4,200,000 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:...