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 22% each of the last three years. Casey 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. Pigeon Company’s discount rate is 18%. The project would provide net operating income each year for five years as follows:

Sales			$	3,700,000
Variable expenses				1,720,000
Contribution margin				1,980,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	730,000
Depreciation		760,000
Total fixed expenses				1,490,000
Net operating income			$	490,000

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	490000
Add: Depreciation	760000
Net cash flows	1250000
1
	Now	Year 1	Year 2	Year 3	Year 4	Year 5
Investment cost	-3800000
Net cash flows		1250000	1250000	1250000	1250000	1250000
Total cash flows	-3800000	1250000	1250000	1250000	1250000	1250000
PV factor @ 18%	1	0.847	0.718	0.609	0.516	0.437
Present value of cash flows	-3800000	1058750	897500	761250	645000	546250
Net present value	108750
2
PV factor internal rate of return=3800000/1250000 = 3.040
The PV factor 3.040 for 5 years is closest to 19%
Internal rate of return = 19%
3
Simple rate of return = Net operating income/Investment cost
Simple rate of return = 490000/3800000= 12.9%
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