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 $3,700,000 investment in equipment with a useful life of five years and no salvage value. Holston Company’s discount rate is 16%. The project would provide net operating income each year for five years as follows: Sales $ 3,100,000 Variable expenses 1,300,000 Contribution margin 1,800,000 Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs $ 660,000 Depreciation 740,000 Total fixed expenses 1,400,000 Net operating income $ 400,000 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

SOLUTION

1. Annual cash flows from the project = Net operating income + Depreciation

= $400,000 + $740,000 = $1,140,000

Present value discount factor of an annuity of $1 at 16% for 5 periods = 3.2743

Present value of cash inflows from the project = $1,140,000 * 3.2743 = $3,732,702

Net present value of the project = $3,732,702 - $3,700,000 = $32,702

2. Project's simple rate of return = Annual operating income / Average investment in the project

= $400,000 / $3,700,000 = 10.81%

3a. Yes, because the net present value of the project is positive using the company' discount rate.

3b. Yes, because the divisions ROI will increase.