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 25% each of the last three years. Derrick is considering a capital budgeting project that would require a $4,650,000 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			$	4,000,000
Variable expenses				1,750,000
Contribution margin				2,250,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	745,000
Depreciation		930,000
Total fixed expenses				1,675,000
Net operating income			$	575,000

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?

Answer 1

1	Net Present Value	=	$         56,135
2	Simple rate of return	=	12.4%
3 - a.	Yes
3 - b.	No
1
		Year	Value Flows	Present Factor @18%	Present Value
	Initial Cost	0	$ -46,50,000	1	$     -46,50,000
	Cash Inflows ($575000 + $930000)	1 - 5	$   15,05,000	3.127	$      47,06,135
	Net Present Value				$            56,135
2	Computation of Simple rate of return:
	Simple rate of return	=	Net Profit / Investment
		=	$575000 / $4650000
		=	12.4%

3 - a.	Yes
	As the Net Present value is positive it is beneficial for company.
3 - b.	No
	ROI	=	25%
	Simple rate of return	=	12.4%
	As, ROI is more than Simple rate of return. It is not recommended to accept the Investment opportunity.