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 $3,080,000 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			$	2,700,000
Variable expenses				1,100,000
Contribution margin				1,600,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	620,000
Depreciation		616,000
Total fixed expenses				1,236,000
Net operating income			$	364,000

Click here to view Exhibit 12B-1 and Exhibit 12B-2, to determine the appropriate discount factor(s) using tables.

Required:

1. Compute the project's net present value.

2. Compute the project's simple rate of return.

3a. Would the company want Derrick to pursue this investment opportunity?

3b. Would Derrick be inclined to pursue this investment opportunity?

Answer 1

(1). Project’s Net Present Value

Annual Cash flow = Net Operating Income + Depreciation

= $364,000 + $616,000

= $980,000

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $980,000(PVIFA 17%, 5 Years) - $3,080,000

= [$980,000 x 3.199] - $3,080,000

= $3,135,020 - $3,080,000

= $55,020

(2)-Project’s simple rate of return

Simple rate of Return = [Net Operating Income / Investment] x 100

= [$364,000 / $3,080,000] x 100

= 11.82%

(3)(a)-Would the company want Derrick to pursue this investment opportunity-YES

(3)(b)-Would Derrick be inclined to pursue this investment opportunity-NO

NOTE

The formula for calculating the Present Value Annuity Inflow Factor (PVIFA) is [{1 - (1 / (1 + r)n} / r], where “r” is the Discount Rate/Cost of capital and “n” is the number of years.