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

Req 1
NET PRESENT VALUE
			NOW	YEAR1	YEAR2	YEAR3	YEAR4	YEAR5
Purchase of equipment			-3,500,000
sales				3,400,000	3,400,000	3,400,000	3,400,000	3,400,000
Vvariable expense				1600000	1600000	1600000	1600000	1600000
Out of pocket cost				700000	700000	700000	700000	700000
Total cash flows			-3,500,000	1100000	1,100,000	1,100,000	1,100,000	1,100,000
Discount factor			1	0.862069	0.743163	0.640658	0.552291	0.476113
Present value			-3500000	948275.9	817479.2	704723.4	607520.2	523724.3
Net present value			101,723
Req 2:
Annual operating profits:
Sales			3,400,000
Less: Variable cost			1,600,000
Less: Total fixed cost			1,400,000
Net operating income			400,000
Average Investment:			1,750,000	(i.e. 3500,000/2)
Rate of return: Average annual income / average investment *100
	($ 400,000 /1750,000 *100 ) = 22.86%
Req 3:
The Company would want casey to Invest in project.