Question

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 $4,700,000 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			$	4,400,000
Variable expenses				2,000,000
Contribution margin				2,400,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	800,000
Depreciation		940,000
Total fixed expenses				1,740,000
Net operating income			$	660,000

Click here to view Exhibit 13B-1 and Exhibit 13B-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 to the nearest whole percent?

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?

Answer 1

Answer :

Year	Cash flows	PVF@19%	Present value
0	$(4,700,000)	1.000	$(4,700,000.00)
1	$1,600,000	0.840	$1,344,537.82
2	$1,600,000	0.706	$1,129,863.71
3	$1,600,000	0.593	$949,465.30
4	$1,600,000	0.499	$797,870.00
5	$1,600,000	0.419	$670,478.99
	660000 + 940000	-	-
IRR	20.82%	-	-
Net present value			$192,215.82
Simple rate of return		14.04%	660000/4700000

(4a).

Net operating income	$6,60,000
Operating assets	$47,00,000
Return on investment	14.04%

Since the company's discount rate is 19% and return on this investment is 14.04% company wil not pursue this investment opportunity. Return on investment is less than the discount rate

(4b).

Net operating income	$6,60,000
Operating assets	$47,00,000
Return on investment	14.04%

Since the Casey is having a ROI of his division above 23% and return on this investment is 14.04% Casey will not pursue this investment opportunity. Return on investment is less than the present ROI of this division.

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