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 $3,800,000 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		$	3,200,000
Variable expenses			1,350,000
Contribution margin			1,850,000
Fixed expenses:
Advertising, salaries, and other fixed          out-of-pocket costs	$670,000
Depreciation	670,000
Total fixed expenses			1,340,000
Net operating income		$	510,000

Click here to view Exhibit 11B-1 and Exhibit 11B-2, to determine the appropriate discount factor(s) using tables.

Required:

1.	Compute the project's net present value. (Use the appropriate table to determine the discount factor(s), 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

We first calculate free cash flows

Free cash flow each year = Net operating income + Depreciation

Net Operating Income = $510,000

Depreciation = $670,000

Therefore Free Cashflow for each year = $1,180,000

Computation of NPV for Holston Company
Particulars	Period	Amount	PV Factor @ 16%	Present Value
Cash Outflows
Initial Investment	0	$3,800,000	1	$3,800,000
Present Value of Cash Outflows (A)	$3,800,000
Cash Inflows
Annual Free cash Inflows	1-5	$1,180,000	3.274	$3,863,320
Present Value of Cash Inflows (B)	$3,863,320
Net Present Value (B) - (A)	$63,320

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

2. Computation of SImple Rate of Return

Simple rate of return = Net operating income / Initial investment

= $510,000 / $3,800,000

= 13.4%

3.a. Yes, the Company would want Derrick to pursue this investment opportunity as NPV is Positive $63,320

3.b. No. As the simple rate of return of 13.4% is below the historical return on investment of 20%, Derrick might be inclined for rejecting the investment opportunity. The concern can be justified on the grounds that implementation of the project can lower the ROI and his next raise in pay

NOTE

The formula for calculating the Present Value Annuity Inflow Factor (PVIFA) is [{1 - (1 / (1 + r)n} / r], where “r” is the Discount Rate/Cost of capital and “n” is the number of years. Or the same can be taken from the annuity factor table