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 7B-1 and Exhibit 7B-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

Note: The Discount Factor Tables are not provided as stated in the problem. The discount factors are accessed from other standard tables, rounded to 3 decimals.

Given, Investment= $4,800,000 and Net operating income (NOI) per year= $690,000

Therefore, yearly cash flow= NOI + Depreciation=$690,000+$960,000= $1,650,000

Project life= 5 year with no salvage value. Discount rate=20%

Part 1:

Net Present Value= 1,650,000*PVIFA(20%,5)-4,800,000= 1,650,000* 2.991-4,800,000 =$135,150

Part 2:

Internal Rate of Return (IRR) is the discount rate which makes PV of the NOI equal to investment

Required Discount factor= 4,800,000/1,650,000= 2.909

PVIFA for 5 years closest to the above discount factor= 2.926 for 21%

Hence IRR nearest to whole percent= 21%

Part 3:

Simple rate of return= Net operating income/Investment= 690,000/4,800,000 = 14.38%

Part 4 a: Since the NPV is positive at the required discount rate of 20%, the company shall pursue it.

Part 4 b: Rate of Return (ROI) is 14.38%, below the past 3 years achievement of 24%. Hence Casey shall not be inclined to pursue this investment opportunity.