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 $4,800,000 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			$	4,500,000
Variable expenses				2,040,000
Contribution margin				2,460,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	810,000
Depreciation		960,000
Total fixed expenses				1,770,000
Net operating income			$	690,000

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

Formula Sheet

A	B	C	D	E	F	G	H	I	J	K
2
3		ROI	0.24
4		Initial Investment	4800000
5		Useful Life	5	years
6		Discount Rate	0.2
7		Tax Rate	0	(Not Given)
8
9		1)
10		First free cash flow needs to be calculated using the following formula:
11		Free Cash Flow = Operating Cash Flow - Capex - Change in working capital
12		Operating Cash Flow = EBIT*(1-T)+Depreciation
13
14		Annual Net Operating Income (EBIT)	690000
15		Tax Expense	=D14*D7
16		EBIT*(1-T)	=D14-D15
17		Annual Depreciation	960000
18		Annual Capex	0
19		Annual Change in Working Capital	=0
20		Annual free Cash Flow	=D16+D17-D18-D19
21
22		NPV for the project can be calculated as follows:
23		Year	0	1	2	3	4	5
24		Incremental Cash Flow	=-D4	=$D$20	=$D$20	=$D$20	=$D$20	=$D$20
25		Discount Rate (i)	0.2
26		(P/F,i,n) for each year		=1/((1+$D25)^E23)	=1/((1+$D25)^F23)	=1/((1+$D25)^G23)	=1/((1+$D25)^H23)	=1/((1+$D25)^I23)
27		Present Value of cash flows = FCF*(P/F,i,n)		=E24*E26	=F24*F26	=G24*G26	=H24*H26	=I24*I26
28		Present value if future cash flows	=SUM(E27:I27)	=SUM(E27:I27)
29
30		NPV for Project	=Present value fo future cash flows - Initial investment
31			=D28+D24	=D28+D24
32
33		Hence NPV for Project	=D31
34
35		2)
36
37		Calculation of IRR:
38		IRR is the rate at which NPV of the project will be zero.
39		Given the following cash flow IRR can be calculated as below:
40
41		Year	0	=D41+1	=E41+1	=F41+1	=G41+1	=H41+1
42		Free Cash Flow	=D24	=E24	=F24	=G24	=H24	=I24
43
44		IRR can be found using IRR function in excel as follows:
45		Year	0	=D45+1	=E45+1	=F45+1	=G45+1	=H45+1
46		Incremental Cash Flow	=D42	=E42	=F42	=G42	=H42	=I42
47		IRR	=IRR(D46:I46)	=IRR(D46:I46)
48
49		IRR of the project	=D47
50
51		3)
52
53		Simple rate of return can be calculated as follows:
54		Simple rate of return	=Increase in net income / Initial Investment
55			=D16/D4	=D16/D4
56
57		Hence simple rate of return	=D55
58
59		4-a)
60
61		Projects with positive NPV are profitable for the company and add value to the company.
62		Since the NPV of the project is positive therefore the company will want Casey to persue the project.
63
64		4-b)
65
66		Casey ROI has been 24% whereas IRR for the project is 21.27% which is less than the earlier ROI.
67		Since addition of new project will decrease the overall ROI, therefore Casey will not be inclined to persue the investment opportunity.
68