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 $5,050,000 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		$	4,700,000
Variable expenses			2,120,000
Contribution margin			2,580,000
Fixed expenses:
Advertising, salaries, and other fixed          out-of-pocket costs	$830,000
Depreciation	1,010,000
Total fixed expenses			1,840,000
Net operating income		$	740,000

  

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? (Round discount factor(s) to 3 decimal places.)

  

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? (Round percentage answer to 1 decimal place. i.e. 0.123 should be considered as 12.3%.)

  

4-a.	Would the company want Casey to pursue this investment opportunity?
	Yes No

4-b.	Would Casey be inclined to pursue this investment opportunity?
	Yes No

Answer 1

Net operating income	740000
Add: Depreciation	1010000
Net cash flows	1750000
1
	Now	Year 1	Year 2	Year 3	Year 4	Year 5
Investment cost	-5050000
Net cash flows		1750000	1750000	1750000	1750000	1750000
Total cash flows	-5050000	1750000	1750000	1750000	1750000	1750000
PV factor @ 20%	1	0.833	0.694	0.579	0.482	0.402
Present value of cash flows	-5050000	1457750	1214500	1013250	843500	703500
Net present value	182500
2
PV factor internal rate of return=5050000/1750000 = 2.886
The PV factor 2.886 for 5 years is closest to 22%
Internal rate of return = 22%
3
Simple rate of return = Net operating income/Investment cost
Simple rate of return = 740000/5050000= 14.7%
4a
Yes, the company would want Casey to pursue this investment as Net Present value is positive
4b
No, Casey would not be inclined to pursue this investment as as his ROI will decrease