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

Net operating income	830000
Add: Depreciation	1170000
Net cash flows	2000000
1
	Now	Year 1	Year 2	Year 3	Year 4	Year 5
Investment cost	-5850000
Net cash flows		2000000	2000000	2000000	2000000	2000000
Total cash flows	-5850000	2000000	2000000	2000000	2000000	2000000
PV factor @ 20%	1	0.833	0.694	0.579	0.482	0.402
Present value of cash flows	-5850000	1666000	1388000	1158000	964000	804000
Net present value	130000
2
PV factor internal rate of return=5850000/2000000 = 2.925
The PV factor 2.925 for 5 years is closest to 21%
Internal rate of return = 21%
3
Simple rate of return = Net operating income/Investment cost
Simple rate of return = 830000/5850000= 14.2%
4a
Yes, the company would want Casey to pursue this investment as Net Present value is positive
4b
No, Casey would not be inclined to pursue this investment as as his ROI will decrease