Question

PROBLEM 13-17 Net Present Value Analysis; Internal Rate of Return; Simple Rate of Return [LO13-2, LO13-3, L013-6] Casey Nelson is a divisional manager for Pigeon Company. His annual pay raises are largely deter- mined by his division's return on investment (ROI), which has been above 20% each of the last three years. Casey is considering a capital budgeting project that would require a $3,500,000 invest- ment in equipment with a useful life of five years and no salvage value, Pigeon Company's discount rate is 16%. The project would provide net operating income each year for five years as follows: $3,400,000 1,600,000 1,800,000 Sales Variable expenses ........ Contribution margin ..... Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs ....... Depreciation ........... Total fixed expenses ......... Net operating income ........ $700,000 700,000 1,400,000 $ 400,000 Required: 1. What is the project's net present value? 2. What is the project's internal rate of return to the nearest whole percent? What is the project's simple rate of return? 4. Would the company want Casey to pursue this investment opportunity? Would Casey be inclined to pursue this investment opportunity? Explain.

Answer 1

1 x fc 1 G H (rounded to 3 decimals) annual cash inflow present value annuity factor (16%, 5 years) present value of total cash inflows cost of equipment project's net present value $ 1,100,000 3.274 $3,601,400 $3,500,000 $ 101,400 cash flow -$ 3,500,000 $ 1,100,000 $ 1,100,000 $ 1,100,000 $ 1,100,000 $ 1,100,000 17% IRR = 3 simple rate of return = annual net income / cost of equipment simple rate of return = $400,000 / $3,500,000 simple rate of return = 11.43% 4a YES, the company would want Casey to pursue this investment opportunity. reason - because the IRR of the project is more than the company's discount rate of 16% NO, Casey would not be inclined to pursue this investment opportunity reason-because the project's rate of return is only 11.43% i.e. less than the 20% required by Casey

for formulas and calculations, refer to the image below -

X fx 1 BC F G H I (rounded to 3 decimals) annual cash inflow =400000+700000 present value annuity factor (16%, 5 years) =ROUND(-PV(16%,5,1),3) present value of total cash inflows =E2*E3 cost of equipment 3500000 project's net present value =E4-E5 year 0 cash flow -3500000 1100000 1100000 1100000 1100000 1100000 =ROUND(IRR(E9:E14),2) IRR = simple rate of return = annual net income / cost of equipment simple rate of return = $400,000 / $3,500,000 simple rate of return = =ROUND(400000/3500000,4) YES, the company would want Casey to pursue this investment opportunity. reason - because the IRR of the project is more than the company's discount rate of 16% NO, Casey would not be inclined to pursue this investment opportunity reason - because the project's rate of return is only 11.43% i.e. less than the 20% required by Casey

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