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 $4,120,000 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			$	3,500,000
Variable expenses				1,500,000
Contribution margin				2,000,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	690,000
Depreciation		824,000
Total fixed expenses				1,514,000
Net operating income			$	486,000

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

1. Compute the project's net present value.

Annual Cash inflow

=486,000+824,000

=$1,310,000

NPV

= PV of cash inflow - PV of cash outflow

= $1,310,000 x PVIFA(17%,5) - $4,120,000

= $$1,310,000 x 3.1993 - $4,120,000

= $4191083-4120,000

=$71,083

NPV=$71,083

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

Simple rate of return

= incremental annual net operating income / initial investment

= $486000 / $4120000

= 11.80%

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

Yes, the company would want Derrick persue this investment opportunity

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

Answer: Yes, Derrick would be inclined to persure this investmen opportunity.