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 23% each of the last three years. Casey is considering a capital budgeting project that would require a $4,700,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company’s discount rate is 19%. The project would provide net operating income each year for five years as follows:

  

Sales		$	4,400,000
Variable expenses			2,000,000
Contribution margin			2,400,000
Fixed expenses:
Advertising, salaries, and other fixed          out-of-pocket costs	$800,000
Depreciation	940,000
Total fixed expenses			1,740,000
Net operating income		$	660,000

  

Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using tables.

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?
	Yes No

4-b.	Would Casey be inclined to pursue this investment opportunity?
	Yes No

Answer 1

1	Net Present Value	=	$     1,92,800
2	IRR	=	21%
3	Simple rate of return	=	14.0%
4 - a.	Yes
4 - b.	No
1
		Year	Value Flows	Present Factor @19%	Present Value
	Initial Cost	0	$ -47,00,000	1	$     -47,00,000
	Cash Inflows ($940000 + $660000)	1 - 5	$   16,00,000	3.058	$      48,92,800
	Net Present Value				$         1,92,800
2	Computation of IRR
		Year	Value Flows
		0	$ -47,00,000
		1	$   16,00,000
		2	$   16,00,000
		3	$   16,00,000
		4	$   16,00,000
		5	$   16,00,000
	IRR	=	21%
3	Computation of Simple rate of return:
	Simple rate of return	=	Net Profit / Investment
		=	$660000 / $4700000
		=	14%
4 - a.	Yes
	As the Net Present value is positive it is beneficial for company.
4 - b.	No
	ROI	=	23%
	Simple rate of return	=	14.0%
	As, ROI is more than Simple rate of return. It is not recommended to accept the Investment opportunity.