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 $5,380,000 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			$	4,800,000
Variable expenses				2,160,000
Contribution margin				2,640,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	840,000
Depreciation		1,076,000
Total fixed expenses				1,916,000
Net operating income			$	724,000

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 flows = Operating income + Depreciation = $724,000 + $1,076,000 = $1,800,000

Computation of NPV - Pigeon Company
Particulars	Amount	Period	PV Factor	Present Value
Cash Outflows:
Cost of Investment	$5,380,000.00	0	1	$5,380,000.00
Present Value of Cash Outflows (A)				$5,380,000.00
Cash Inflows:
Annual cash inflows	$1,800,000.00	1-5	3.05763	$5,503,742.80
Present Value of Cash Inflows (B)				$5,503,742.80
Net Present Value (B-A)				$123,742.80

Solution 2:

Period	Cash Flows	IRR
0	-$5,380,000.00	20%
1	$1,800,000.00
2	$1,800,000.00
3	$1,800,000.00
4	$1,800,000.00
5	$1,800,000.00

Solution 3:

Project simple rate of return = Net operating income / Initial investment = $724,000 / $5,380,000 = 13.46%

Solution 4a:

As IRR offered by project is 20% which is higher than required return of the company, therefore company want Casey to pursue this investment opportunity.

Solution 4b:

Casey do not want to pursue this investment opportunity as ROI offered by investment is lesser than 23%, therefore it will decrease overall ROI of the division.