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 $3,000,000 investment in equipment with a useful life of five years and no salvage value. Holston Company’s discount rate is 15%. The project would provide net operating income each year for five years as follows:

Sales			$	2,500,000
Variable expenses				1,000,000
Contribution margin				1,500,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	600,000
Depreciation		600,000
Total fixed expenses				1,200,000
Net operating income			$	300,000

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

Part-1

Net annual cash inflow from the project = net operating income + depreciation = 300000+$600000 = $900000

NPV= PV of cash inflow - PV of cash outflow

= $900000 x PVIFA(15%,5) - $4160000

= $900000 x 3.3522 - $3000000

=16980

2)

Simple rate of return

= incrementotal annual net operating income / initial investment

= 300000 /3000000= 10%

3(a) Yes the company want derrick pursue this investment opportunity as NPV is positivve

3(b) Yes the derrick would not be pursue this opportuity as Simple rate of return is lesses than Required return of 20%