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 $4,900,000 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			$	4,600,000
Variable expenses				2,080,000
Contribution margin				2,520,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	820,000
Depreciation		980,000
Total fixed expenses				1,800,000
Net operating income			$	720,000

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?

What is the project’s net present value? (Round your final answer to the nearest whole dollar amount.)

	Net present value

What is the project’s internal rate of return? (Round your answer to whole decimal place i.e. 0.123 should be considered as 12%.)

	Internal rate of return %

What is the project’s simple rate of return? (Round percentage answer to 1 decimal place.)

	Simple rate of return %

Would the company want Casey to pursue this investment opportunity?

	Yesradio button unchecked1 of 2 Noradio button unchecked2 of 2

Would Casey be inclined to pursue this investment opportunity?

	Yesradio button unchecked1 of 2 Noradio button unchecked2 of 2

Answer 1

Solution:-

1. The net present value is computed as follows:-

Particulars	Now	1	2	3	4	5
Purchase of equipment	(4,900,000)
Sales		4,600,000	4,600,000	4,600,000	4,600,000	4,600,000
Variable expenses		2,080,000	2,080,000	2,080,000	2,080,000	2,080,000
Out-of-pocket costs		820,000	820,000	820,000	820,000	820,000
Total cash flows (a)	(4,900,000)	1,700,000	1,700,000	1,700,000	1,700,000	1,700,000
Discount factor (b)	1.000	0.833	0.694	0.579	0.482	0.402
Present value (a)×(b)	(4,900,000)	1,416,100	1,179,800	984,300	819,400	683,400

Net present value = $

2. The internal rate of return is computed as follows:-

= 2.882 (rounded)

Looking in Exhibit 13B-2 and scanning along the 5-period line, a factor of 2.882 falls closest to the factor for 22%. Thus, to the nearest whole percent, the internal rate of return is %.

3. The simple rate of return is computed as follows:-

= %

4 (a) Would the company want Casey to pursue this investment opportunity:-

4 (b) Would Casey be inclined to pursue this investment opportunity:-

Explanation to 4 (a) and 4 (b):-

The company would want Casey to invest in the project because it has a positive net present value of $183,000 and an internal rate of return of 22%. However, Casey might be inclined to reject the project because its simple rate of return of 14.7% is well below his historical return on investment (ROI) of 24%. Casey may be justifiably concerned that implementing this project would lower his ROI and his next pay raise.