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 25% each of the last three years. Derrick is considering a capital budgeting project that would require a $4,650,000 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		$	4,000,000
Variable expenses			1,750,000
Contribution margin			2,250,000
Fixed expenses:
Advertising, salaries, and other fixed          out-of-pocket costs	$745,000
Depreciation	745,000
Total fixed expenses			1,490,000
Net operating income		$	760,000

Use Excel or a financial calculator to solve.

Required:

1.	Compute the project's net present value to the nearest dollar.

  

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

Net operating income	760000
Add: Depreciation	745000
Net annual cash flows	1505000
1
	Year 1	Year 2	Year 3	Year 4	Year 5
Net annual cash flows	1505000	1505000	1505000	1505000	1505000
X PV factor @ 18%	0.847	0.718	0.609	0.516	0.437
Present value of Net annual cash flows	1275424	1080868	915989	776262	657849
Total present value	4706392
Less: Investment cost	4650000
Net present value	56392
2
Simple rate of return = Net operating income/Investment cost
Simple rate of return = 760000/4650000= 16.3%
3a
Yes, the company would want Derrick to pursue to this investment opportunity
3b
No, Derrick would not be inclined to pursue to this investment opportunity as his ROI will decrease