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 21% each of the last three years. Casey is considering a capital budgeting project that would require a $3,700,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company’s discount rate is 17%. The project would provide net operating income each year for five years as follows:

Sales			$	3,600,000
Variable expenses				1,680,000
Contribution margin				1,920,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	720,000
Depreciation		740,000
Total fixed expenses				1,460,000
Net operating income			$	460,000

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

1. Computation of NPV.
Cash Inflow per year	$1,200,000	($460,000 + $740,000)
(Net Operating income + Depreciation)
No. of years	5
PVIF (17%,5)	3.19935
Present Value of Cash Inflows	$3,839,215	($1,200,000 * 3.19935)
(Cash Inflows * PVIF)
Less: Initial Investment	$3,700,000	(Given)
Net Present Value (NPV)	$139,215

2. Computation of IRR
IRR in where NPV is $0
	Amount
Cash Outflows in Year 0	-$3,700,000	($460,000 + $740,000)
Cash Inflow Year 1	$1,200,000
Cash Inflow Year 2	$1,200,000
Cash Inflow Year 3	$1,200,000
Cash Inflow Year 4	$1,200,000
Cash Inflow Year 4	$1,200,000
IRR	19%	=IRR(B16:B21)

3. Computation of Simple Rate of Return

Rate of Return = (Net Operating Income / Investment) * 100

=($460,000 / $3,700,000) * 100

=12.43%

4. a. Yeas as it has positive NPV and higher IRR than discounting rate, so the company would definitely want Casey to pursue this investment Opportunity.

4.b. No, Casey won't be interested as it had 19% of IRR which is less than the 21% ROI which she already receives.