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 24% each of the last three years. Casey is considering a capital budgeting project that would require a $5,850,000 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 $ 5,200,000 Variable expenses 2,320,000 Contribution margin 2,880,000 Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs $ 880,000 Depreciation 1,170,000 Total fixed expenses 2,050,000 Net operating income $ 830,000 Brewer_8e_Rechecks_2020_01_30 Click here to view Exhibit 12B-1 and Exhibit 12B-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

1)Net present value = $130,000

2)Internal rate of return = 21%

3)Simple rate of return = 14.2 %

4-a)Yes

4-b)No

Step-by-step explanation:

As per the data given in the question,

Net operating income = $830,000

Depreciation = $1,170,000

Net cash flow = $830,000 + $1,170,000

= $2,000,000

1)

Now Year 1 Year 2 Year 3 Year 4 Year 5

Investment cost -$5,850,000

Net cash flow $2,000,000 $2,000,000 $2,000,000 $2,000,000 $2,000,000

Total cash flow -$5,850,000 $2,000,000 $2,000,000 $2,000,000 $2,000,000 $2,000,000

Pv factor 20% 1 0.833 0.694 0.579 0.482 0.402

Present value

of cash flow -$5,850,000 $1,666,000 $1,388,000 $1,158,000 $964,000 $804,000

Net present value $130,000

2)

PV factor internal rate of return =$5,850,000÷$2,000,000

= 2.925

PV factor 2.925 for 5 years is closest to 21%

Hence Internal rate of return = 21%

3)

Simple rate of return = Net operating income÷Investment cost

=$830,000÷$5,850,000

= 14.2%

Hence Simple rate of return= 14.2 %

4 a)

Yes, Since net present value is positive therefore company would want Casey to pursue this investment.

4 b)

No, Casey will not pursue this investment because his ROI will decrease.