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 $3,200,000 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: $2,800,000 1,150,000 1,650,000 Sales Variable expenses Contribution margin Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs Depreciation Total fixed expenses $ 610,000 640,000 1,250,000 $ 400,000 Net operating income Click here to view Exhibit 12B-1 and Exhibit 12B-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

Solution 1:

Annual cash inflows = Net operating income + Depreciation = $400,000 + $640,000 = $1,040,000

Computation of NPV - Holston Company
Particulars	Period	Amount	PV factor at 18%	Present Value
Cash outflows:
Cost of expansion	0	$3,200,000.00	1	$3,200,000
Present Value of Cash outflows (A)				$3,200,000
Cash Inflows
Annual cash inflows	1-5	$1,040,000.00	3.127	$3,252,080
Present Value of Cash Inflows (B)				$3,252,080
Net Present Value (NPV) (B-A)				$52,080

Solution 2:

Simple rate of return = Net operating income / Initial investment = $400,000 / $3,200,000 = 12.50%

Solution 3a:

Yes, company want derrick to pursue this investment opportunity as NPV is positive.

Solution 3b:

Derrick do not want to pursue this investment opportunity as it will result in decrease in Overall ROI of the division.