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 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: Sales $ 3,400,000 Variable expenses 1,600,000 Contribution margin 1,800,000 Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs $ 700,000 Depreciation 700,000 Total fixed expenses 1,400,000 Net operating income $ 400,000 Click here to view Exhibit 14B-1 and Exhibit 14B-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

Answer:

1. What is the project’s net present value?

• NPV = $101,723

2. What is the project’s internal rate of return?

• IRR = 17.24%

3. What is the project’s simple rate of return?

• simple rate of return = 11.43%

4-a. Would the company want Casey to pursue this investment opportunity?

• Yes, since the NPV is positive

4-b. Would Casey be inclined to pursue this investment opportunity?

• No, since it will decrease the average ROI

Explanation:

initial outlay = -$3,500,000

cash flow years 1-5 = $400,000 + $700,000 = $1,100,000

discount rate = 16%

using a financial calculator:

NPV = $101,723

IRR = 17.24%

simple rate of return = $400,000 / $3,500,000 = 11.43%