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

660,000

  Total fixed expenses

1,320,000

  Net operating income

$

480,000

Use Excel or a financial calculator to solve.

Required:

PART1.

Compute the project's net present value to the nearest dollar.

PART2.

Compute the project's simple rate of return. (Round your answer to 1 decimal place. i.e. 0.123 should be considered as 12.3%.)

PART3-a.

Would the company want Derrick to pursue this investment opportunity? Yes or No

PART3-b.

Would Derrick be inclined to pursue this investment opportunity? Yes or No

Answer 1

Annual cash inflows
Net income			480000
Add: Annual depreciation			660000
Annual cash inflowws			1140000
Annuity present value factor			3.2743
(16 % for 5 yrs)
Present value of Annual cash inf			3732702
Less: Initial Investment			3,700,000
NPV			32702
Rate of return simple:
Annual net income			480000
Divide: Average investment			1850000
(3700000+0) /2
Simple rate of return			25.95%
( 480000 / 1850000) *100
Yes, company wants to pursue as NPV is positive at 16% cut off rate
Yes, Derrick wants to pursue as rate of return is higher than 20%