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

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

Net operating income	550000
Add: Depreciation	800000
Net cash flows	1350000
1
	Now	Year 1	Year 2	Year 3	Year 4	Year 5
Investment cost	-4000000
Net cash flows		1350000	1350000	1350000	1350000	1350000
Total cash flows	-4000000	1350000	1350000	1350000	1350000	1350000
PV factor @ 19%	1	0.840	0.706	0.593	0.499	0.419
Present value of cash flows	-4000000	1134000	953100	800550	673650	565650
Net present value	126950
2
PV factor internal rate of return= 4000000/1350000 = 2.963
The PV factor 2.963 for 5 years is closest to 20%
Internal rate of return = 20%
3
Simple rate of return = Net operating income/Investment cost
Simple rate of return = 550000/4000000= 13.8%
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