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 $3,000,000 investment in equipment with a useful life of five years and no salvage value. Holston Company�s discount rate is 15%. The project would provide net operating income each year for five years as follows:

Sales		$	2,500,000
Variable expenses			1,000,000
Contribution margin			1,500,000
Fixed expenses:
Advertising, salaries, and other fixed          out-of-pocket costs	$600,000
Depreciation	600,000
Total fixed expenses			1,200,000
Net operating income		$	300,000

1.	Compute the project's net present value. (Round discount factor(s) to 3 decimal places.) 2. Compute the project's simple rate of return. (Round your answer to whole decimal place i.e. 0.123 should be considered as 12%)

Answer 1

Concepts and reason

Cash: Cash is the currency notes and coins held by an entity. It is the physical form of currency held. Currency, money orders, timely deposits are included in cash. Cash is reported under the current assets section in the balance sheet.

Cash inflows: Cash inflows are the receipts from a project in cash. These are estimated to analyze whether such project should be accepted or not. These cash inflows represent revenue from the project on cash basis.

Cash outflows: Cash outflows for a project is the amount of payments in cash. These are estimated to analyze whether such project should be accepted or not. These cash outflows represent expenses from the project on cash basis.

Initial investment: Initial investment is the amount of cash outflow to start a project. It is the large amount of cash outflow. This initial investment will be recovered in parts within the term of the project.

Fundamentals

Net Present Value [NPV]: Net present value is the present value of cash flows from a project during its term. The present value of cash flows is computed using a present value factor. This net present value will be analyzed to take decision about the project whether it should be accepted or not. Net present value is calculated as shown below:

Simple Rate of Return: Simple rate of return represents percentage of income earned for every dollar of investment made. It is computed by dividing the net income earned with the investment made. Simple rate of return is calculated as shown below:

1.

Calculate the project’s annual cash inflows as shown below:

Thus, the amount of project’s annual cash inflows is.

Compute the project’s net present value as shown below:

Thus, the project’s net present value is.

2.

Compute the project’s simple rate of return as shown below:

Thus, the project’s simple rate of return is.

Ans: Part 1

The project’s net present value is $16,940.

Part 2

The project’s simple rate of return is 10%.