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.What is the project’s net present value?

Cash Flow = Net Income + Depreciation

                   = $550000 + 800000 = $13,50,000

Net present value (NPV) at 19% = $1,27,801

= [ $13,50,000 x (PVAF 19%,5 Years) ] - $40,00,000

= [ ($1350000 x 3.05763 ) - $40,00,000

= $1,27,801

2. What is the project’s internal rate of return to the nearest whole percent?

Present Value Factor     = $40,00,000 / $1350000

                                      = 2.96296

From the PVA Factor Table, IRR corresponding to 2.96296 for 5 years = 20%

Therefore, Internal Rate of Return = 20%

3. What is the project’s simple rate of return?

simple rate of return = (Net Income / Initial Investments) * 100

= ($550000 / 4000000) * 100

= 13.75%

4-a. Would the company want Casey to pursue this investment opportunity?

YES

4-b. Would Casey be inclined to pursue this investment opportunity?

YES