Question

Derrick Iverson is a divisional manager for Holston 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. Derrick is considering a capital budgeting project that would require a $4,140,000 investment in equipment with a useful life of five years and no salvage value. Holston Company’s discount rate is 16%. The project would provide net operating income each year for five years as follows:

Sales			$	3,400,000
Variable expenses				1,450,000
Contribution margin				1,950,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	670,000
Depreciation		828,000
Total fixed expenses				1,498,000
Net operating income			$	452,000

1. Compute the project's net present value.

2. Compute the project's simple rate of return.

3a. Would the company want Derrick to pursue this investment opportunity?

3b. Would Derrick be inclined to pursue this investment opportunity?

Answer 1

Net operating income	452000
Add: Depreciation	828000
Net annual cash flows	1280000
1
	Year 1	Year 2	Year 3	Year 4	Year 5
Net annual cash flows	1280000	1280000	1280000	1280000	1280000
X PV factor @ 16%	0.862	0.743	0.641	0.552	0.476
Present value of Net annual cash flows	1103360	951040	820480	706560	609280
Total present value	4190720
Less: Investment cost	4140000
Net present value	50720
2
Simple rate of return = Net operating income/Investment cost
Simple rate of return = 452000/4140000= 10.9%
3a
Yes the company would want Derrick to pursue to this investment opportunity
3b
No, Derrick would not be inclined to pursue to this investment opportunity as his ROI will decrease