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

Click here to view Exhibit 8B-1 and Exhibit 8B-2, to determine the appropriate discount factor(s) using tables.

Required:

1. What is the project’s net present value? (Round discount factor(s) to 3 decimal places.)

  

2. What is the project’s internal rate of return to the nearest whole percent?

  

3. What is the project’s simple rate of return? (Round percentage answer to 1 decimal place. i.e. 0.123 should be considered as 12.3%.)

  

Answer 1

Net annual cash flows = Net operating income + Depreciation
Net annual cash flows = 830000+1170000= $2000000
1
	Annual net cash flows	PV factor	Present value
Year 1	2000000	0.833	1666000
Year 2	2000000	0.694	1388000
Year 3	2000000	0.579	1158000
Year 4	2000000	0.482	964000
Year 5	2000000	0.402	804000
Total present value	5980000
Less: Investment cost	-5850000
Net present value	130000
2
PV factor for internal rate of return = Investment cost/Annual cash flows
PV factor for internal rate of return = 5850000/2000000= 2.925
The PV factor 2.925 for 5 years us closest to 21%
Internal rate of return = 21%
3
Simple rate of return = Net operating income /Investment cost
Simple rate of return = 830000/5850000= 14.2%