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 20% each of the last three years. Casey is considering a capital budgeting project that would require a $3,500,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company's discount rate is 16%. The project would provide net operating income each year for the five years as follows:

Sales...... ..................$3,400,000

Variable Expenses...1,600,000

Contribution Margin...1,800,000

Fixed Expenses:

Advertising, salaries, & other fixed out of pocket costs.... $700,000

Depreciation.................................................700,000

Total FIxed Expenses...................................................................................1,400,000

Net Operating income...................................................................................$400,000

Problem 11-13A

1. The net present value is computed as follows:

	Now	1	2	3	4	5
Purchase of equipment...............
Sales........................
Variable expenses.....
Out-of-pocket costs.	__________
Total cash flows (a)..
Discount factor (b)...
Present value (a)×(b)................................
Net present value.....

2. The simple rate of return is computed as follows:

    

3. The company would want Casey to

Answer 1

Answer 1.
Year	Now	1	2	3	4	5
Purchase of Equipment	(3,500,000)	-	-	-	-	-
Sales		3,400,000	3,400,000	3,400,000	3,400,000	3,400,000
Variable Expenses		(1,600,000)	(1,600,000)	(1,600,000)	(1,600,000)	(1,600,000)
Out of Pocket Costs		(700,000)	(700,000)	(700,000)	(700,000)	(700,000)
Total Cash Flow	(3,500,000)	1,100,000	1,100,000	1,100,000	1,100,000	1,100,000
Discount Factor - 16%	1.00000	0.86207	0.74316	0.64066	0.55229	0.47611
Present Value	(3,500,000)	948,276	817,479	704,723	607,520	523,724
NPV	101,723
Answer 2.
Simple Rate of return = Annual Incremental Net Operating Income / Intial Investment
Simple Rate of return = $400,000 / $3,500,000
Simple Rate of return = 11.43% (Approx.)
Answer 3.
Accept the Project