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 22% each of the last three years. Casey is considering a capital budgeting project that would require a $3,900,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company’s discount rate is 18%. The project would provide net operating income each year for five years as follows:

Sales			$	3,800,000
Variable expenses				1,760,000
Contribution margin				2,040,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	740,000
Depreciation		780,000
Total fixed expenses				1,520,000
Net operating income			$	520,000

Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using tables.

Required:

1. What is the project’s net present value?

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?

4-a. Would the company want Casey to pursue this investment opportunity?

4-b. Would Casey be inclined to pursue this investment opportunity?

Answer 1

A)

Projects cashflow = net operating income + depreciation

= $520000 + $780000

= $1300000

Year	cash flows	discount factor @ 18%	discounted cashflows
0	-$3900000	1	-$3900000
1	$1300000	0.847	$1101100
2	$1300000	0.718	$933400
3	$1300000	0.609	$791700
4	$1300000	0.516	$670800
5	$1300000	0.437	$568100
			$165100

B)

Using excel IRR function;

=IRR(-$3900000,1300000,1300000,1300000,1300000,1300000)

= 19.86%

C)

Simple rate of return = {(Inflows - Outflows)/Initial investment}/no of years

= (($6,500,000 - $3,900,000)/$3,900,000)/5 = ($2,600,000/$3,900,000)/5 = 13.33%

D)

Yes because return i.e. IRR is more then cost of capital and PV is also positive

D)

As simple rate of interest is lower then the required ROI she wont be inclined to pursue