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 $5,160,000 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		$	4,400,000
Variable expenses			1,950,000
Contribution margin			2,450,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$790,000
Depreciation	1,032,000
Total fixed expenses			1,822,000
Net operating income		$	628,000

   

Click here to view Exhibit 8B-1 and Exhibit 8B-2, to determine the appropriate discount factor(s) using tables.

Required:

1. Compute the project's net present value. (Round discount factor(s) to 3 decimal places, intermediate calculations and final answer to the nearest dollar amount.)

2. Compute the project's simple rate of return. (Round your answer to 1 decimal place. i.e. 0.123 should be considered as 12.3%.)

3-a. Would the company want Derrick to pursue this investment opportunity?

	Yes
	No

3-b. Would Derrick be inclined to pursue this investment opportunity?

	Yes
	No

Answer 1

Net operating income	628000
Add: Depreciation	1032000
Net annual cash flows	1660000
1
	Year 1	Year 2	Year 3	Year 4	Year 5
Net annual cash flows	1660000	1660000	1660000	1660000	1660000
X PV factor @ 18%	0.847	0.718	0.609	0.516	0.437
Present value of Net annual cash flows	1406020	1191880	1010940	856560	725420
Total present value	5190820
Less: Investment cost	5160000
Net present value	30820
2
Simple rate of return = Net operating income/Investment cost
Simple rate of return = 628000/5160000= 12.2%
3a
Yes, the company would want Derrick to pursue to this investment opportunity
3b
No, Derrick would not be inclined to pursue to this investment opportunity as his ROI will decrease