Question

Simmons Company 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? the margin is not 35.70 and the turnover is not 400,000

Answer 1

Marginal Sales | Marginal Cost Marginal Flows pv Factor @16% PV Flows pv Factor @18.75% PV Flows 1.0000 -8,00,000 0.84211,26,316 0.70911,06,371 0.5972 89,576 0.59724,77,737 Year Income at 16% Residual Income Capital 0-8,00,000 4,00,000 4,00,000 4,00,000 2,50,000 2,50,000 2,50,000 8,00,000 1,50,000 1,50,000 1,50,000 8,00,000 1.0000 -8,00,000 0.8621 1,29,310 0.74321,11,474 0.640796,099 0.64075,12,526 1,28,000 1,28,000 1,28,000 22,000 22,000 22,000 8,00,000 NPV 49,410 NPV IRR 18.75%

1.)

The NPV is $49,410

2.)

The total margin return and roi cannot be found out as the information has not been provided. The following are the marginal (increased) amounts for the investment opportunity.

Annual Margin is $150,000

Turnover is $400,000

And ROI is 18.75%

3,)

$22,000 is the residual income the final $800,000 is just divestment of the working capital.

4.)

The store manager would not want to pursue it because, his return for this particular investment opportunity is lower than his average of 22% (18,75%) and hence would bring his ROI down.

[As we don't know the current position, we cannot find exactly by how much, it would be less]

The company however would want the manager to pursue it, as it will earn the additional marginal income of $49,410 as it's Required rate of return is lower (16%)

Good Luck