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Exercise 13-9 Net Present Value Analysis and Simple Rate of Return [LO13-2, LO13-6] Derrick Iverson is...

Exercise 13-9 Net Present Value Analysis and Simple Rate of Return [LO13-2, LO13-6]

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 $4,480,000 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 $ 3,900,000
Variable expenses 1,700,000
Contribution margin 2,200,000
Fixed expenses:
Advertising, salaries, and other fixed
out-of-pocket costs		 $ 740,000
Depreciation 896,000
Total fixed expenses 1,636,000
Net operating income $ 564,000

Click here to view Exhibit 13B-1 and Exhibit 13B-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?

Solutions

Expert Solution

Answer 1

Given That

Net Operating Income ==> $564,000

Depreciation ==> $896,000

Annual Net Cash Flow ==> $564,000 + $896,000 ==> $1,460,000

Also, Given that

n ==> 5 & i ==> 18%

PV(Present Value)

==> Net Cash Flow * Pv factor

==> $1,460,000 * 3.127 ==> $4,565,420

PV(Present Value) ==> $4,565,420

NPV (Net Present Value) ==> PV cash inflows - PV cash out flows

==> $4,565,420 - $4,480,000

NPV ==> $85,420

Answer 2

simple rate of return:

==> Net operating income/Initaial Investment

==> $564,000/$4,480,000 ==> 0.1258

simple rate of return==> 12.58%

Answer 3a

Yes, Company want Derrick to pursue this opportunity because its simple rate of return(ROR) is 12.58% which is less than discount rate of 18%.

Answer 3b

Here the answer is NO, because of the simple ROR(Rate of Return) is 12.58% which is less than division’s return on investment (ROI) which is above 20% of last 3 Yrs.

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