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 11B-1 and Exhibit 11B-2, to determine the appropriate discount factor(s) using tables.

    

Required:
1.	What is the project’s net present value? (Use the appropriate table to determine the discount factor(s).) 2. What is the project’s simple rate of return? (Round percentage answer to 1 decimal place. i.e. 0.123 should be considered as 12.3%.)

3-a.	Would the company want Casey to pursue this investment opportunity?
	Yes No

3-b.	Would Casey be inclined to pursue this investment opportunity?
	Yes No

Answer 1

(1) What is the project’s net present value?

Net present value (NPV) at 20% = $1,36,385 (Positive)

Annual Cash flow          = Net Income + Depreciation

= $6,10,000 + $8,40,000

= $14,50,000

Net present value (NPV) = Present Vale of cash flows – Estimated costs

= [ $14,50,000 x (PVAF 20%,5Years) ] -$42,00,000

= [ $14,50,000 x 2.99061- $42,00,000

= $43,36,385 - $42,00,000

= $1,36,385 (Positive)

(2) What is the project’s simple rate of return?

Project’s simple rate of return = 14.5%

Simple rate of Return    = (Net Income/Investment) x 100

                                      = ($6,10,000 / $42,00,000) x 100

                                      = 14.5%     

3(a) Would the company want Casey to pursue this investment opportunity = YES

3(b) Would Casey be inclined to pursue this investment opportunity = YES