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 $4,200,000 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			$	4,100,000
Variable expenses				1,880,000
Contribution margin				2,220,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	770,000
Depreciation		840,000
Total fixed expenses				1,610,000
Net operating income			$	610,000

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:

Solution 2:

Solution 3:

Solution 4a:

Yes,  the company would want Casey to pursue this investment opportunity as IRR is greater than discount rate.

Solution 4b:

No, Casey would not be inclined to pursue this investment opportunity as its simple rate of return is less than divisional ROI.