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 $4,200,000 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			$	4,100,000
Variable expenses				1,880,000
Contribution margin				2,220,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	770,000
Depreciation		840,000
Total fixed expenses				1,610,000
Net operating income			$	610,000

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

1	Net Present Value	=	$     1,36,950
2	IRR	=	21%
3	Simple rate of return	=	14.5%
4 - a.	Yes
4 - b.	No
1
		Year	Value Flows	Present Factor @20%	Present Value
	Initial Cost	0	$ -42,00,000	1	$     -42,00,000
	Cash Inflows ($610000 + $840000)	1 - 5	$   14,50,000	2.991	$      43,36,950
	Net Present Value				$         1,36,950
2	Computation of IRR
		Year	Value Flows
		0	$ -42,00,000
		1	$   14,50,000
		2	$   14,50,000
		3	$   14,50,000
		4	$   14,50,000
		5	$   14,50,000
	IRR	=	21%
3	Computation of Simple rate of return:
	Simple rate of return	=	Net Profit / Investment
		=	$610000 / $4200000
		=	14.5%

4 - a.	Yes
	As the Net Present value is positive it is beneficial for company.
4 - b.	No
	ROI	=	24%
	Simple rate of return	=	14.5%
	As, ROI is more than Simple rate of return. It is not recommended to accept the Investment opportunity.
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