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 24% each of the last three years. Casey is considering a capital budgeting project that would require a $5,950,000 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			$	5,300,000
Variable expenses				2,360,000
Contribution margin				2,940,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	890,000
Depreciation		1,190,000
Total fixed expenses				2,080,000
Net operating income			$	860,000

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

Annual cash inflows:
Net income			860000
Add: Depreciation expenses			1190000
Annual cash inflows:			2050000
NPV:
Annual inflows			2050000
Annuity PVF at 20% for 5 years			2.990612
Present value of inflows			6130755
Less: Initial Investment			5950000
NPV			180754.6
IRR:
Annual inflows			2050000
Annuity PVF at 21.4% for 5 years			2.90078
Present value of inflows			5946599
Less: Initial Investment			5950000
NPV			-3401
IRR = 21.40%
Req 3.
Net Income annual				860000
Divide: Average Investment (5950000/2):				2975000
Simple rate of return				28.91%
Req 4-a:
Yes, company shall pursue this investment opportunity.
Req 4-b:
Yes, Casey shall inclined to pursue the opporutnity as Rate of return is more than targeted 24%