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 20% each of the last three years. Derrick is considering a capital budgeting project that would require a $3,560,000 investment in equipment with a useful life of five years and no salvage value. Holston Company’s discount rate is 16%. The project would provide net operating income each year for five years as follows:

  

Sales		$	3,000,000
Variable expenses			1,250,000
Contribution margin			1,750,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$650,000
Depreciation	712,000
Total fixed expenses			1,362,000
Net operating income		$	388,000

   

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

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1	Net Present Value	=	$         41,400
2	Simple rate of return	=	10.9%
3 - a.	Yes
3 - b.	No
1
		Year	Value Flows	Present Factor @16%	Present Value
	Initial Cost	0	$ -35,60,000	1	$     -35,60,000
	Cash Inflows ($388000 + $712000)	1 - 5	$   11,00,000	3.274	$      36,01,400
	Net Present Value				$            41,400
2	Computation of Simple rate of return:
	Simple rate of return	=	Net Profit / Investment
		=	$388000 / $3560000
		=	10.9%

3 - a.	Yes
	As the Net Present value is positive it is beneficial for company.
3 - b.	No
	ROI	=	20%
	Simple rate of return	=	10.9%
	As, ROI is more than Simple rate of return. It is not recommended to accept the Investment opportunity.