Question

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 $4,140,000 investment in equipment with a useful life of five years and no salvage value. Holston Company’s discount rate is 16%. The project would provide net operating income each year for five years as follows:

  

Sales		$	3,400,000
Variable expenses			1,450,000
Contribution margin			1,950,000
Fixed expenses:
Advertising, salaries, and other fixed          out-of-pocket costs	$670,000
Depreciation	670,000
Total fixed expenses			1,340,000
Net operating income		$	610,000

Click here to view Exhibit 11B-1 and Exhibit 11B-2, to determine the appropriate discount factor(s) using tables.

Required:

1.	Compute the project's net present value. (Use the appropriate table to determine the discount factor(s), intermediate calculations and final answer to the nearest dollar amount.)

  

2.	Compute the project's simple rate of return. (Round your answer to 1 decimal place. i.e. 0.123 should be considered as 12.3%.)

  

3-a.	Would the company want Derrick to pursue this investment opportunity?
	Yes No

3-b.	Would Derrick be inclined to pursue this investment opportunity?
	Yes No

Answer 1

(1). Project’s Net Present Value

Annual Cash flow = Net Operating Income + Depreciation

= $610,000 + $670,000

= $12,80,000

Year	Annual Cash Flow ($)	Present Value factor at 16%	Present Value of Cash Flow ($)
1	12,80,000	0.862	11,03,360
2	12,80,000	0.743	9,51,040
3	12,80,000	0.641	8,20,480
4	12,80,000	0.552	7,06,560
5	12,80,000	0.476	6,09,280
TOTAL			41,90,720

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $41,90,720 - $41,40,000

= $50,720

“Net Present Value (NPV) = $50,720”

(2)-Project’s simple rate of return

Simple rate of Return = [Net Operating Income / Investment] x 100

= [$610,000 / $41,40,000] x 100

= 14.7%

“Project’s simple rate of return = 14.7%”

(3)(a)-Would the company want Derrick to pursue this investment opportunity – YES

(3)(b)-Would Derrick be inclined to pursue this investment opportunity – NO

NOTE    

The Formula for calculating the Present Value Factor is [1/(1 + r)ⁿ], Where “r” is the Discount/Interest Rate and “n” is the number of years.