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 $3,800,000 investment in equipment with a useful life of five years and no salvage value. Holston Company’s discount rate is 16%. The project would provide net operating income each year for five years as follows:

Sales			$	3,200,000
Variable expenses				1,350,000
Contribution margin				1,850,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	670,000
Depreciation		760,000
Total fixed expenses				1,430,000
Net operating income			$	420,000

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

Required:

1. Compute the project's net present value.

2. Compute the project's simple rate of return.

3a. Would the company want Derrick to pursue this investment opportunity?

3b. Would Derrick be inclined to pursue this investment opportunity?

Answer 1

Solution 1:

Annual net Cash Inflow
Net Operating Income	$4,20,000
Add: Depreciation	$7,60,000
Net Cash Flow	$11,80,000

	Chart Values are based on
	n=	5
	i=	16%
Cash Flow	Select Chart	Amount	*	PV Factor	=	Present Value
Annual Net cash Inflow	Present Value of an annuity of 1	$11,80,000		3.274	=	$38,63,320
	Present value of cash inflows					$38,63,320
	Present value of cash outflows					-$38,00,000
	Net Present Value					$63,320

Solution 2:

Simple rate of Return
Choose Numerator	/	Choose Denominator	=	Accounting Rate of Return
Annual Net operating Income	/	Initial Investment	=	Accounting Rate of Return
$4,20,000	/	$38,00,000	=	11.1%

Solution 3:

No, the company would not want Derrick to pursue this investment opportunity as its Simple rate of return (11.1%) is less than discount rate (16%).

Solution 4:

No, Derrick would not be inclined to pursue this investment opportunity as as its Simple rate of return (11.1%) is less than Division's ROI (20%).