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 $3,600,000 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 five years as follows:

Sales			$	3,500,000
Variable expenses				1,640,000
Contribution margin				1,860,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	710,000
Depreciation		720,000
Total fixed expenses				1,430,000
Net operating income			$	430,000

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?

Answer 1

Net operating income	430000
Add: Depreciation	720000
Net cash flows	1150000
1
	Now	Year 1	Year 2	Year 3	Year 4	Year 5
Investment cost	-3600000
Net cash flows		1150000	1150000	1150000	1150000	1150000
Total cash flows	-3600000	1150000	1150000	1150000	1150000	1150000
PV factor @ 16%	1	0.862	0.743	0.641	0.552	0.476
Present value of cash flows	-3600000	991300	854450	737150	634800	547400
Net present value	165100
2
PV factor internal rate of return= 3600000/1150000 = 3.130
The PV factor 3.130 for 5 years is closest to 18%
Internal rate of return = 18%
3
Simple rate of return = Net operating income/Investment cost
Simple rate of return = 430000/3600000= 11.9%
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