Question

Cardinal Company is considering a five-year project that would require a $2,860,000 investment in equipment with a useful life of five years and no salvage value. The company’s discount rate is 14%. The project would provide net operating income in each of five years as follows:

Sales			$	2,859,000
Variable expenses				1,100,000
Contribution margin				1,759,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	700,000
Depreciation		572,000
Total fixed expenses				1,272,000
Net operating income			$	487,000

13. Assume a postaudit showed that all estimates (including total sales) were exactly correct except for the variable expense ratio, which actually turned out to be 50%. What was the project’s actual net present value?
14. Assume a postaudit showed that all estimates (including total sales) were exactly correct except for the variable expense ratio, which actually turned out to be 50%. What was the project’s actual payback period?
15. Assume a postaudit showed that all estimates (including total sales) were exactly correct except for the variable expense ratio, which actually turned out to be 50%. What was the project’s actual simple rate of return?

Answer 1

Solution 13:

Variable expense ratio = 50%

Actual variable Expense = Sales *50% = $2,859,000 *50% = $1,429,500

Annual cash inflows = Sales - variable expenses - Fixed out of pocket expenses = $2859000 - $1429500 - $700000 = $729,500

Present value of cash Inflows = Annual Cash Inflows * Cumulative PV factor for 5 years @14% = $729500*3.43308 =$2,504,432.57 (rounded to 2 decimal places)

Net Present value = Present value of cash Inflows - initial investment = $2,504,432.57 - $2,860,000

= - $355,567.43

Solution 2:

Annual cash Inflows = $729,500

Initial investment = $2,860,000

Payback period = Inital Investment / Annual cash Inflows = $2860000 / $729500 = 3.92 years

Solution 3:

Simple rate of return = Annual net operating income form project / Initial Investment

Actual Annual Net operting income = $487,000 - (increase in actual variable expenses) = $487000 - ($1429500 - $1100000) = $157500

Simple rate of return = $157500 / $2860000 = 5.507% (rounded)