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 for five follows: year ( 5 marks) years as Sales... Variable expenses $2,500,000 1,000,000 ........ Contribution margin.... Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs .... Depreciation.... 1,500,000 $800,000 600,000 Total fixed expenses 1200,000 $ 300,00 Net operating income .... 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)
Initial Investment			=	$3,000,000
Net Operating Income			=	$300,000
Add: Depreciation			=	$600,000
Net Annual Cash Flows			=	$900,000
Calculation of Present Value of Net Annual Cash Flows
Year	Net Annual Cash Flows	PV factor @ 15%		PV of Net Annual Cash Flows
1	$900,000	0.869		$782,100
2	$900,000	0.756		$680,400
3	$900,000	0.658		$592,200
4	$900,000	0.571		$513,900
5	$900,000	0.497		$447,300
TOTAL				$3,015,900
PV of Net Annual Cash Flows			=	$3,015,900
Less: Initial Investment			=	$3,000,000
Net Present Value			=	$15,900
2)
Simple Rate of Return			=	Net Income	*	100
				Initial Investment
			=	$300,000	*	100
				$3,000,000
			=	10%

3) NPV is positive. This Investment opportunity should be availed by Derrick.