In: Finance
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?
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 . |