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 24% each of the last three years. Casey is considering a capital budgeting project that would require a $4,200,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company’s discount rate is 20%. The project would provide net operating income each year for five years as follows:
| Sales | $ | 4,100,000 | ||
| Variable expenses | 1,880,000 | |||
| Contribution margin | 2,220,000 | |||
| Fixed expenses: | ||||
| Advertising,
salaries, and other fixed out-of-pocket costs |
$ | 770,000 | ||
| Depreciation | 840,000 | |||
| Total fixed expenses | 1,610,000 | |||
| Net operating income | $ | 610,000 | ||
Click here to view Exhibit 13B-1 and Exhibit 13B-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 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?
4-b. Would Casey be inclined to pursue this investment opportunity?
| Net operating income | 610000 | |||||
| Add: Depreciation | 840000 | |||||
| Net cash flows | 1450000 | |||||
| 1 | ||||||
| Now | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Investment cost | -4200000 | |||||
| Net cash flows | 1450000 | 1450000 | 1450000 | 1450000 | 1450000 | |
| Total cash flows | -4200000 | 1450000 | 1450000 | 1450000 | 1450000 | 1450000 |
| PV factor @ 20% | 1 | 0.833 | 0.694 | 0.579 | 0.482 | 0.402 |
| Present value of cash flows | -4200000 | 1207850 | 1006300 | 839550 | 698900 | 582900 |
| Net present value | 135500 | |||||
| 2 | ||||||
| PV factor internal rate of return=4200000/1450000 = 2.897 | ||||||
| The PV factor 2.897 for 5 years is closest to 21% | ||||||
| Internal rate of return = 21% | ||||||
| 3 | ||||||
| Simple rate of return = Net operating income/Investment cost | ||||||
| Simple rate of return = 610000/4200000= 14.5% | ||||||
| 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 | ||||||
Casey Nelson is a divisional manager for Pigeon Company. His annual pay raises are largely determined...
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