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 25% each of the last three years. Derrick is considering a capital budgeting project that would require a $4,650,000 investment in equipment with a useful life of five years and no salvage value. Holston Company’s discount rate is 18%. The project would provide net operating income each year for five years as follows:

  

Sales		$	4,000,000
Variable expenses			1,750,000
Contribution margin			2,250,000
Fixed expenses:
Advertising, salaries, and other fixed          out-of-pocket costs	$745,000
Depreciation	745,000
Total fixed expenses			1,490,000
Net operating income		$	760,000

Use Excel or a financial calculator to solve.

Required:

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

Net present value

$44

2b.	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%.)

Simple rate of return

34.0

%

3-a.

Would the company want Derrick to pursue this investment opportunity?

	Yes
	No

3-b.

Would Derrick be inclined to pursue this investment opportunity?

	Yes
	No

  

Answer 1

1) Calculation of Net Present Value of Project:-

Annual Cash Flow:- Net Income after tax+Depreciation per year

= $760,000+$745,000 = $1,505,000

Cash flow	Select Chart	Amount		PV Factor		Present Value
Annual Cash Flow	Present Value of Annuity of 1 (18%,5 yrs)	$1,505,000	*	3.12717	=	4,706,391
	Present value of cash inflows					4,706,391
	Immediate Cash Outflows					4,650,000
	Net Present value					56,391

2-b Calculation of Simple rate of return:-

Simple Rate of Return = (Operating Income/Initial Investment)*100

= ($760,000/$4,650,000)*100

= 16.3%

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

Yes, because the NPV from the given project is positive the company would want to invest.

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

Yes,Derrick will be inclined to pursue this investment as it is giving good rate of return and positive NPV.