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 24% each of the last three years. Casey is considering a capital budgeting project that would require a $5,850,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company’s discount rate is 20%. The project would provide net operating income each year for five years as follows:

Sales			$	5,200,000
Variable expenses				2,320,000
Contribution margin				2,880,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	880,000
Depreciation		1,170,000
Total fixed expenses				2,050,000
Net operating income			$	830,000

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.

Annual cash flow = Net operating income + depreciation

                               = $ 830,000 + $ 1,170,000 = $ 20,00,000

PV of cash inflows = Cash flow x PVIFA (i, n)

PVIFA = Present value interest factor of annuity

i = rate of interest = 20 %

n = No. of years = 5 & Annuity factor (1/1+i)n

PV of cash inflows = $ x PVIFA (20%, 5)

                                  = $ 20,00,000 x 2.99061214 = $ 59,81,224

NPV = PV of cash inflows – Investment = $ 59,81,224 - $ 5,850,000

                                                                     = $ 1,31,224

2.

Year	Cash Flow
0	$    (5,850,000)
1	$ 20,00,000
2	$    20,00,000
3	$   20,00,000
4	$   20,00,000
5	$   20,00,000
IRR	21%

AT IRR present value of cash in flows = cash out flows

Annuity factor at 21%=2.925

20,00,000*2.925=58,50,000

3.

Simple rate of return = Incremental net operating income/ Investment

$ 830,000/$ 58,50,000 = 0.1418 (or) 14.2%

4a)

Company would want Casey to pursue the investment opportunity as NPV is positive and IRR is higher than discount rate of Pigeon Company.

4b)

Casey wouldn’t be inclined to pursue the investment opportunity as return of project is less than 24 %.