Question

Problem 12-17 Net Present Value Analysis; Internal Rate of Return; Simple Rate of Return [LO12-2, LO12-3, LO12-6]

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 $5,510,000 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			$	4,900,000
Variable expenses				2,200,000
Contribution margin				2,700,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	850,000
Depreciation		1,102,000
Total fixed expenses				1,952,000
Net operating income			$	748,000

Brewer_8e_Rechecks_2020_01_30

Click here to view Exhibit 12B-1 and Exhibit 12B-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?

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

1	Net Present Value	=	$     1,47,300
2	IRR	=	20%
3	Simple rate of return	=	13.6%
4 - a.	Yes
4 - b.	No
1
		Year	Value Flows	Present Factor @19%	Present Value
	Initial Cost	0	$ -55,10,000	1	$     -55,10,000
	Cash Inflows ($748000 + $1102000)	1 - 5	$   18,50,000	3.058	$      56,57,300
	Net Present Value				$         1,47,300
2	Computation of IRR
		Year	Value Flows
		0	$ -55,10,000
		1	$   18,50,000
		2	$   18,50,000
		3	$   18,50,000
		4	$   18,50,000
		5	$   18,50,000
	IRR	=	20%
3	Computation of Simple rate of return:
	Simple rate of return	=	Net Profit / Investment
		=	$748000 / $5510000
		=	13.6%

4 - a.	Yes
	As the Net Present value is positive it is beneficial for company.
4 - b.	No
	ROI	=	23%
	Simple rate of return	=	13.6%
	As, ROI is more than Simple rate of return. It is not recommended to accept the Investment opportunity.