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 $4,900,000 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			$	4,600,000
Variable expenses				2,080,000
Contribution margin				2,520,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	820,000
Depreciation		980,000
Total fixed expenses				1,800,000
Net operating income			$	720,000

Brewer_8e_Rechecks_2020_01_30

Click here to view Exhibit 12B-1 and Exhibit 12B-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?

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

Pigeon Company
Investment in Equipment	$           4,900,000
Discount Rate	20%
Annual Operating Cash flow calculation
Annual Net Operating Income	$              720,000
Add back Depreciation	$              980,000
Operating Cash flow	$           1,700,000

	NPV Calculation :
	Details	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
	Initial Investment
a	Investment in Equipment	$         (4,900,000)
b	Cash flow from Operation		$          1,700,000	$               1,700,000	$          1,700,000	$        1,700,000	$       1,700,000
c	Free cash flow from Project =a+b=	$         (4,900,000)	$          1,700,000	$               1,700,000	$          1,700,000	$        1,700,000	$       1,700,000
d	PV factor @20%=1/1.2^n	1	0.83333	0.69444	0.57870	0.48225	0.40188
e	PV of FCF =c*d=	$   (4,900,000.00)	$     1,416,666.67	$          1,180,555.56	$        983,796.30	$      819,830.25	$     683,191.87
f	NPV=Sum of PV of FCF =	$        184,040.64	Ans 1.
g	IRR =(using excel formula)	21.70%	Ans 2.

Ans 3.
Net Operating Income =	720,000
Investment =	4,900,000
Simple return =720,000/4,900,000=	14.69%

Ans 4.a

As NPV is positive and IRR > hurdle rate , the company would want Casey to

pursue this investment opportunity.

Ans 4.b.

However, the ROI of this project (14.69%) is lower than the last 3 years

average ROI (24%) of his division , Casey would not want to pursue this

investment opportunity as this would not help in his pay raise .