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

1
Net operating income	400000
Add: Depreciation	740000
Net annual cash flows	1140000
Net annual cash flows	PV factor	Present value
1140000	0.862	982680
1140000	0.743	847020
1140000	0.641	730740
1140000	0.552	629280
1140000	0.476	542640
Total present value		3732360
Less: Investment cost		3700000
Net present value		32360
2
Simple rate of return = Net operating income/Investment cost
Simple rate of return = 400000/3700000=10.8%
3a
Yes, as the Net present value in positive
b
No, his division’s return on investment (ROI) will decrease