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 20% each of the last three years. Casey is considering a capital budgeting project that would require a $3,500,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company’s discount rate is 16%. The project would provide net operating income each year for five years as follows:

  

Sales		$	3,400,000
Variable expenses			1,600,000
Contribution margin			1,800,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$700,000
Depreciation	700,000
Total fixed expenses			1,400,000
Net operating income		$	400,000

  

Required:

1. What is the project’s net present value? (Round discount factor(s) to 3 decimal places.)

Answer 1

Annual Net operating income = $400,000

Annual Depreciation = $700,000

Annual cash inflow = Annual Net operating income + Annual Depreciation

= 400,000 + 700,000

= $1,100,000

Discount rate (i) = 16%

Time period (n) = 5 years

Present value of cash inflows = Annual cash inflow x Present value annuity factor (i%, n)

= 1,100,000 x Present value annuity factor (16%, 5)

= 1,100,000 x 3.274

= $3,601,400

Initial investment = $3,500,000

Project’s net present value = Present value of cash inflows - Initial investment

= 3,601,400 - 3,500,000

= $101,400