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 $3,080,000 investment in equipment with a useful life of five years and no salvage value. Holston Company’s discount rate is 17%. The project would provide net operating income each year for five years as follows:

Sales			$	2,700,000
Variable expenses				1,100,000
Contribution margin				1,600,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	620,000
Depreciation		616,000
Total fixed expenses				1,236,000
Net operating income			$	364,000

Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using tables.

Required:

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	364000
Add: Depreciation	616000
Net annual cash flows	980000
1
	Year 1	Year 2	Year 3	Year 4	Year 5
Net annual cash flows	980000	980000	980000	980000	980000
X PV factor @ 17%	0.855	0.731	0.624	0.534	0.456
Present value of Net annual cash flows	837900	716380	611520	523320	446880
Total present value	3136000
Less: Investment cost	3080000
Net present value	56000
2
Simple rate of return = Net operating income/Investment cost
Simple rate of return = 364000/3080000= 11.8%
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