Question

Problem 12-17 Net Present Value Analysis; Internal Rate of Return; Simple Rate of Return (LO12-2, LO12- 3, LO12-6] 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 20% each of the last three years. Casey is considering a capital budgeting project that would require a $3,500,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company's discount rate is 16%. The project would provide net operating income each year for five years as follows: $ 3,400,000 1,600,000 1,800,000 Sales Variable expenses Contribution margin Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs Depreciation Total fixed expenses Net operating income $ 700,000 700,000 1,400,000 400,000 $ Click here to view Exhibit 12B-1 and Exhibit 12B-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? 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

Net operating income	400000
Add: Depreciation	700000
Net cash flows	1100000
1
	Now	Year 1	Year 2	Year 3	Year 4	Year 5
Investment cost	-3500000
Net cash flows		1100000	1100000	1100000	1100000	1100000
Total cash flows	-3500000	1100000	1100000	1100000	1100000	1100000
PV factor @ 16%	1	0.862	0.743	0.641	0.552	0.476
Present value of cash flows	-3500000	948200	817300	705100	607200	523600
Net present value	101400
2
PV factor internal rate of return=3500000/1100000 = 3.182
The PV factor 3.182 for 5 years is closest to 17%
Internal rate of return = 17%
3
Simple rate of return = Net operating income/Investment cost
Simple rate of return = 400000/3500000= 11.4%
4a
Yes, the company would want Casey to pursue this investment as Net Present value is positive
4b
No, Casey would not be inclined to pursue this investment as as his ROI will decrease