Question

Q4. 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 $4,450,000 investment in equipment with a useful life of five years and no salvage value. Holston Company’s discount rate is 18%. The project would provide net operating income each year for five years as follows:

Sales			$	3,800,000
Variable expenses				1,650,000
Contribution margin				2,150,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	710,000
Depreciation		890,000
Total fixed expenses				1,600,000
Net operating income			$	550,000

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

Q6.

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 23% each of the last three years. Casey is considering a capital budgeting project that would require a $5,510,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company’s discount rate is 19%. The project would provide net operating income each year for five years as follows:

Sales			$	4,900,000
Variable expenses				2,200,000
Contribution margin				2,700,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	850,000
Depreciation		1,102,000
Total fixed expenses				1,952,000
Net operating income			$	748,000

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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?

Q7.

Lou Barlow, a divisional manager for Sage Company, has an opportunity to manufacture and sell one of two new products for a five-year period. His annual pay raises are determined by his division’s return on investment (ROI), which has exceeded 23% each of the last three years. He has computed the cost and revenue estimates for each product as follows:

	Product A			Product B
Initial investment:
Cost of equipment (zero salvage value)	$	300,000		$	500,000
Annual revenues and costs:
Sales revenues	$	350,000		$	450,000
Variable expenses	$	160,000		$	210,000
Depreciation expense	$	60,000		$	100,000
Fixed out-of-pocket operating costs	$	80,000		$	61,000

The company’s discount rate is 16%.

Click here to view Exhibit 12B-1 and Exhibit 12B-2, to determine the appropriate discount factor using tables.

Required:

1. Calculate the payback period for each product.

2. Calculate the net present value for each product.

3. Calculate the internal rate of return for each product.

4. Calculate the project profitability index for each product.

5. Calculate the simple rate of return for each product.

6a. For each measure, identify whether Product A or Product B is preferred.

6b. Based on the simple rate of return, Lou Barlow would likely:

Answer 1

Answer to Question 4:

Initial Investment = $4,450,000

Annual Net Cash flows = Annual Net Operating Income + Annual Depreciation
Annual Net Cash flows = $550,000 + $890,000
Annual Net Cash flows = $1,440,000

Answer 1.

Net Present Value = -$4,450,000 + $1,440,000 * PVA of $1 (18%, 5)
Net Present Value = -$4,450,000 + $1,440,000 * 3.127
Net Present Value = $52,880

Answer 2.

Simple Rate of Return = Annual Net Income / Initial Investment
Simple Rate of Return = $550,000 / $4,450,000
Simple Rate of Return = 12.4%

Answer 3-a.

The company would want Derrick to pursue this investment opportunity as NPV is positive.

Answer 3-b.

Derrick would be inclined to pursue this investment opportunity as simple rate of return is less than 20.00%.

Answer to Question 6:

Initial Investment = $5,510,000

Annual Net Cash flows = Annual Net Operating Income + Annual Depreciation
Annual Net Cash flows = $748,000 + $1,102,000
Annual Net Cash flows = $1,850,000

Answer 1.

Net Present Value = -$5,510,000 + $1,850,000 * PVA of $1 (19%, 5)
Net Present Value = -$5,510,000 + $1,850,000 * 3.058
Net Present Value = $147,300

Answer 2.

Present Value Factor = Initial Investment / Annual Net Cash Flows
Present Value Factor = $5,510,000 / $1,850,000
Present Value Factor = 2.978

Using financial table, IRR is 20%

Internal Rate of Return = 20%

Answer 3.

Simple Rate of Return = Annual Net Income / Initial Investment
Simple Rate of Return = $748,000 / $5,510,000
Simple Rate of Return = 13.6%

Answer 4-a.

The company would want Casey to pursue this investment opportunity as NPV is positive.

Answer 4-b.

Casey would be inclined to pursue this investment opportunity as simple rate of return is less than 23.00%.