Question

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 $4,120,000 investment in equipment with a useful life of five years and no salvage value. Holston Company’s discount rate is 17%. The project would provide net operating income each year for five years as follows:

  

Sales		$	3,500,000
Variable expenses			1,500,000
Contribution margin			2,000,000
Fixed expenses:
Advertising, salaries, and other fixed          out-of-pocket costs	$690,000
Depreciation	690,000
Total fixed expenses			1,380,000
Net operating income		$	620,000

Click here to view Exhibit 11B-1 and Exhibit 11B-2, to determine the appropriate discount factor(s) using tables.

Required:

1.	Compute the project's net present value. (Use the appropriate table to determine the discount factor(s), intermediate calculations and final answer to the nearest dollar amount.)

  

2.	Compute the project's simple rate of return. (Round your answer to 1 decimal place. i.e. 0.123 should be considered as 12.3%.)

  

3-a.	Would the company want Derrick to pursue this investment opportunity?
	Yes No

3-b.	Would Derrick be inclined to pursue this investment opportunity?
	Yes No

Answer 1

Solution 1:

Annual net Cash Inflow
Net Operating Income	$6,20,000
Add: Depreciation	$6,90,000
Net Cash Flow	$13,10,000

	Chart Values are based on
	n=	5
	i=	17%
Cash Flow	Select Chart	Amount	*	PV Factor	=	Present Value
Annual Net cash Inflow	Present Value of an annuity of 1	$13,10,000		3.199	=	$41,90,690
	Present value of cash inflows					$41,90,690
	Present value of cash outflows					-$41,20,000
	Net Present Value					$70,690

Solution 2:

Simple rate of Return
Choose Numerator	/	Choose Denominator	=	Accounting Rate of Return
Annual Net operating Income	/	Initial Investment	=	Accounting Rate of Return
$6,20,000	/	$41,20,000	=	15.0%

Solution 3-a:

No, the company would not want Derrick to pursue this investment opportunity as the simple rate of return (15%) is less than discounted return (17%).

Solution 3-b:

No, Derrick would not be inclined to pursue this investment opportunity as the simple rate of return (15%) is less than his division's ROI (20%).