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 $5,050,000 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			$	4,700,000
Variable expenses				2,120,000
Contribution margin				2,580,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	830,000
Depreciation		1,010,000
Total fixed expenses				1,840,000
Net operating income			$	740,000

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

Solution 1:

Annual cash inflows = Net operating income + Depreciation = $740,000 + $1,010,000 = $1,750,000

Computation of NPV - Pigeon company
Particulars	Period	Amount	PV factor at 20%	Present Value
Cash outflows:
Initial investment	0	$5,050,000.00	1	$5,050,000
Present Value of Cash outflows (A)				$5,050,000
Cash Inflows
Annual cash inflows	1-5	$1,750,000.00	2.991	$5,234,250
Present Value of Cash Inflows (B)				$5,234,250
Net Present Value (NPV) (B-A)				$184,250

Solution 2:

Computation of IRR
Period	Cash Flows	IRR
0	-$5,050,000.00	22%
1	$1,750,000.00
2	$1,750,000.00
3	$1,750,000.00
4	$1,750,000.00
5	$1,750,000.00

Solution 3:

Simple rate of return = Net operating income / Initial investment = $740,000 / $5,050,000 = 14.65%

Solution 4:

As NPV is positive therefore company want casey to pursue this investment opportunity.

Solution 5:

No Casey do not want pursue this investment opportunity as it will result in decrease of ROI of the division,