Question

1. 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:

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

  

B. What is the project’s internal rate of return to the nearest whole percent?

       

C. What is the project’s simple rate of return? (Round percentage answer to 1 decimal place. i.e. 0.123 should be considered as 12.3%.)

  

Answer 1

Answer:

1.) Net Present value Method:

NPV =Present value of cash flows - Initial outlay
=($1100000 x (1-1/(1+0.16)² / 0.16) ) - $3500000
=$101723.019

Working Notes:
Cash flow from project = Net operating income + Depreciation
=$400000+$700000
=$1100000

2.) Internal Rate of Return:
Annuity present value factor = Investment cost / Cash inflows
=$3500000/$1100000
=3.182

The present value of annuity table of fifth year shows that the present value factor is 3.182 and the internal rate of return on for PV factor in present value table is 17%

3.) Simple rate of return:
Simple rate of return = (Net Profit / Initial Investment)
=$400000/$3500000
=11.4%

The project is not accepted.