Question

Casey Nelson is a divisional manager for Pigeon Company. His annual pay raises are largely determined by his division’s return on investment (ROI), which has been above 24% each of the last three years. Casey is considering a capital budgeting project that would require a $5,850,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company’s discount rate is 20%. The project would provide net operating income each year for five years as follows:

Sales			$	5,200,000
Variable expenses				2,320,000
Contribution margin				2,880,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	880,000
Depreciation		1,170,000
Total fixed expenses				2,050,000
Net operating income			$	830,000

Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using tables.

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?

3. What is the project’s simple rate of return?

4-a. Would the company want Casey to pursue this investment opportunity?

4-b. Would Casey be inclined to pursue this investment opportunity?

Answer 1

	Yearly Net Operating Income	830,000
	Add: Depreciation	1,170,000
	Total yearly Net Cash Flow	2,000,000
1	NPV
	Year	Cash Flow	NPV
	0	-5,850,000	-5,850 ,000
	1	2,000,000	1,666,667
	2	2,000,000	1,388,889
	3	2,000,000	1,157,407
	4	2,000,000	964,506
	5	2,000,000	803,755
	Total NPV		131,224
	NPV	Cash Flow*(1+r)^-t
2	Internal rate of return
	Year	Cash Flow
	0	-5,850,000
	1	2,000,000
	2	2,000,000
	3	2,000,000
	4	2,000,000
	5	2,000,000
	PV factor internal rate of return=5850000/2000000 = 2.925
	IRR	21%
3	Simple rate of return
		Average profit/ Investment
	Simple rate of return	830000/5850000
		14.19%

4-a	No. because rate of return is lower than previous

4-b	yes - Because positive NPV

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