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 $5,950,000 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			$	5,300,000
Variable expenses				2,360,000
Contribution margin				2,940,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	890,000
Depreciation		1,190,000
Total fixed expenses				2,080,000
Net operating income			$	860,000

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 %

Answer 1

Net operating income	860000
Add: Depreciation	1190000
Net cash flows	2050000
1
	Now	Year 1	Year 2	Year 3	Year 4	Year 5
Investment cost	-5950000
Net cash flows		2050000	2050000	2050000	2050000	2050000
Total cash flows	-5950000	2050000	2050000	2050000	2050000	2050000
PV factor @ 20%	1	0.833	0.694	0.579	0.482	0.402
Present value of cash flows	-5950000	1707650	1422700	1186950	988100	824100
Net present value	179500
2
PV factor internal rate of return=5950000/2050000 = 2.902
The PV factor 2.902 for 5 years is closest to 21%
Internal rate of return = 21%
3
Simple rate of return = Net operating income/Investment cost
Simple rate of return = 860000/5950000= 14.5%
4a
Yes, the company would want Casey to pursue this investment as Net Present value is positive
4b
No, Casey would not be inclined to pursue this investment as as his ROI will decrease