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 25% each of the last three years. Derrick is considering a capital budgeting project that would require a $5,150,000 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 $4,300,000 Variable expenses 1,900,000 Contribution margin 2,400,000 Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs$765,000 Depreciation765,000 Total fixed expenses 1,530,000 Net operating income $870,000 Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using tables.1. Compute the project's net present value.net present value2. Compute the project's simple rate of return.simple rate of return percent

Answer 1

1. $80,855.50

2. 16.89%

Step-by-step explanation:

The computations are shown below:

1. The computation of the Net present value is shown below

= Present value of all yearly cash inflows after applying discount factor + salvage value - initial investment

where,

The Initial investment is $5,150,000

All yearly cash flows would be

= Net operating income + depreciation expense

= $870,000 + $765,000

= $1,635,000

The yearly cash flows would be

= Annual cash flows × PVIFA for 5 years at 17%

= $1,635,000 × 3.1993

= $5,230,855.50

Refer to the PVIFA table

Now put these values to the above formula

So, the value would equal to

= $5,230,855.50 - $5,150,000

= $80,855.50

b. The formula to compute the simple rate of return is shown below:

= Annual net operating income ÷ Initial investment

= $870,000 ÷ $5,150,000

= 16.89%