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 $3,050,000 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 $ 2,600,000 Variable expenses 1,050,000 Contribution margin 1,550,000 Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs $ 600,000 Depreciation 610,000 Total fixed expenses 1,210,000 Net operating income $ 340,000 Click here to view Exhibit 12B-1 and Exhibit 12B-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	340000
Add: Depreciation	610000
Net annual cash flows	950000
1
	Year 1	Year 2	Year 3	Year 4	Year 5
Net annual cash flows	950000	950000	950000	950000	950000
X PV factor @ 16%	0.862	0.743	0.641	0.552	0.476
Present value of Net annual cash flows	818900	705850	608950	524400	452200
Total present value	3110300
Less: Investment cost	3050000
Net present value	60300
2
Simple rate of return = Net operating income/Investment cost
Simple rate of return = 340000/3050000= 11.1%
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