Question

Exercise 11-7 Net Present Value Analysis and Simple Rate of Return [LO11-2, LO11-4]

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 $4,200,000 investment in equipment with a useful life of five years and no salvage value. Holston Company’s discount rate is 18%. The project would provide net operating income each year for five years as follows:

  

Sales		$	3,600,000
Variable expenses			1,550,000
Contribution margin			2,050,000
Fixed expenses:
Advertising, salaries, and other fixed          out-of-pocket costs	$700,000
Depreciation	700,000
Total fixed expenses			1,400,000
Net operating income		$	650,000

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

Calculation of Cash returns per year.
Sales			$ 3,600,000.00
Variable expenses			$ 1,550,000.00
Contribution margin			$ 2,050,000.00
Fixed expenses:
Advertising, salaries, and other fixed	$     700,000.00
out-of-pocket costs
Depreciation	$     700,000.00
Total fixed expenses			$ 1,400,000.00
Net operating income			$     650,000.00
Add: (non Cash Expense) Depreciation			$       700,000.00
Net Cash Return Per year			$    1,350,000.00

Part 1	Year	Cash Inflow (Outflow)	Discount Factor at 18%	Discounted Cash Flows
	0	$ (4,200,000.00)	1	$ (4,200,000.00)
	1	$    1,350,000.00	0.847458	$    1,144,067.80
	2	$    1,350,000.00	0.718184	$       969,548.98
	3	$    1,350,000.00	0.608631	$       821,651.68
	4	$    1,350,000.00	0.515789	$       696,314.98
	5	$    1,350,000.00	0.437109	$       590,097.44
	Net Present Value			$          21,680.88

Part 2	Simple rate of return	Return per year*100
		Initial Investment
		1350000*100
		4200000
		32.1%

Part 3a	Yes.
	The Present value of Investment is Positive and Return is more than 20% so company would want derrick to continue
Part 3b	Yes.
	The Present value of Investment is Positive and Return is more than 20% so company would want derrick to continue