Question

In: Finance

Casey Nelson is a divisional manager for Pigeon Company. His annual pay raises are largely determined...

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?

Solutions

Expert Solution

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 .

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