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 $3,000,000 investment in equipment with a useful life of five years and no salvage value. Holston Company’s discount rate is 15%. The project would provide net operating income each year for five years as follows:

Sales			$	2,500,000
Variable expenses				1,000,000
Contribution margin				1,500,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	600,000
Depreciation		600,000
Total fixed expenses				1,200,000
Net operating income			$	300,000

Click here to view Exhibit 13B-1 and Exhibit 13B-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

Answer- 1)- The project’s net present value =$16980.

Explanation- Net present value = Present value of cash inflows – Total outflows

     ={($900000*3.3522) - $3000000}

     = $3016980 - $3000000

     = $16980

Where – Annual cash inflow = Net income+ Annual depreciation expense

= $300000+$600000

= $900000

2)- The project's simple rate of return is =10%.

Explanation- Project's simple rate of return= (Net operating income/ Total investments)*100

= ($300000/$3000000)*100

= 10%

3-a)- YES- The company want Derrick to pursue this investment opportunity.

   b)- YES- Derrick would be inclined to pursue this investment opportunity.