Question

1A-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 $3,000,000 investment in equipment with a useful life of five years and no salvage value. Holston Company's discount rate is 15%. The project would provide net operating income each year five years follows: (5 marks) for Sales ...... $2,500,000 1,000,000 1,500,000 Variable expenses ............... Contribution margin ................. Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs ................... Depreciation. Total fixed expenses ..................... Net operating income ................ $600,000 600,000 1,200,000 $ 300,000 Required: 1. Compute the project's net present value. (2 marks) 2. Compute the project's simple rate of return. (2 marks) 3. Would the company want Derrick to pursue this investment opportunity? Would Derrick be

Answer 1

1)

Purchase of equipment	-3,000,000
Sales		2,500,000
Variable expenses		-1,000,000
Out-of-pocket costs		-600,000
Total cash flows	-3,000,000	900,000
Discount factor at 15%	1	3.352
Present value	-3,000,000	3,016,800
Net Present Value	16,800

2) Simple rate of return: Annual incremental net income / Initial investment = $300,000 / $3,000,000 = 10%

3) Since NPV is positive thus Derrick should pursue the investment opportunity. However as the simple rate of return of 10% is below the historical return on investment of 20% thus Derrick might be inclined for rejecting the investment opportunity. The concern can be justified on the grounds that implementation of the project can lower the ROI and his next raise in pay