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 23% each of the last three years. Casey is considering a capital budgeting project that would require a $4,000,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company’s discount rate is 19%. The project would provide net operating income each year for five years as follows:

Sales			$	3,900,000
Variable expenses				1,800,000
Contribution margin				2,100,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	750,000
Depreciation		800,000
Total fixed expenses				1,550,000
Net operating income			$	550,000

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. NPV

Annual Cash flow = Net operating income + depreciation

= 550000+800000 = 13,50,0000

Present value annuity facctor @ 19% for 5 years = 3.058

NPV = 3.058x 13,50,000-40,00,000 = 128300

2. IRR is the rate at which NPV will become zero

hence PVAF @ R % ,5 years x 13,50,000= 40,00,000

PVAF @ R %, 5 years = 2.963

From the Present value annuity factor table in 5 year raw at 20% we will get 2.991

NPV @ 20% = 2.991 x 13,50,000-40,00,000 = 37850

Now take PVAF @ 21% from table (We want to get lesser NPV, so taking the next highest percentage from the table)

NPV @ 21 % = 2.926 x 1350000-40,00,000=49900

So, IRR = 20% + (37850/37850+49900) x 1%

= 20.43%

3. Simple rate of return

Rate of return = Average net operating income / average investment

= 550000/4000000

= 13.75%

4a. When considering the NPV of the project the company may insist Casey to undertake the project. The project gives a positive NPV, generally capital budgetting decisions are taken based on the NPV of the project

4b. Mr Casey may not be interested to take the project because his annual pay is based on the ROI investment. Presently tthe comapny is earning 23% and the proposed project only generates 13.75%. He might be interested in investing the amount in the same business which generates 23% return so that his annual pay will be higher.