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 $3,200,000 investment in equipment with a useful life of five years and no salvage value. Holston Company’s discount rate is 18%. The project would provide net operating income each year for five years as follows:

Sales			$	2,800,000
Variable expenses				1,150,000
Contribution margin				1,650,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	610,000
Depreciation		640,000
Total fixed expenses				1,250,000
Net operating income			$	400,000

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

Derrec Iverson:
Q1
Sr.No.	Particulars	Amounts ($)	Amounts ($)
1	Sales		2,800,000.00
2	Variable Expenses		1,150,000.00
3	Contribution Margin (1-2)		1,650,000.00
4	Advertising, Salary and other fixed out of pocket expenses	610,000.00
5	Depreciation	640,000.00
6	Total Fixed Expenses (4+5)		1,250,000.00
7	Net Operating Income (3-6)		400,000.00
8	Net Operating Cashflow (5+7)		1,040,000.00
	The project is giving constant cashflow for 5 years, so it an annuity for 5 years. Present Value Annuity Factor for 5 years @ 18% = 3.1272
	Therefore, Present value of cashflows = 3.1272 * 1040000 = 3252288
	Net Present Value = 3252288 - 3200000 = 52288
Q2	Simple Rate of return of the project:
	= Net present value / Initial Investment
	= 1040000 / 3200000
	32.50%
	i.e. 32.50% for 5 Years i.e. 6.50% p.a.
Q3	Company would definitely want derric to persue this investment opportunity, as the project is giving positive return over the 5 years term. This will increase company's net cashflow and wealth.
Q4	Derrick would not be interested in performing this project as his annual pay raises are determined by ROI given by his division and he has shown ROI of 20% in past periods. Whereas, this investment will give return of only 6.50% p.a. this will adversely affect derricks's pay increase. So, derrick will not be inclined to pursue this project.