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 23% each of the last three years. Casey is considering a capital budgeting project that would require a $4,100,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company’s discount rate is 19%. The project would provide net operating income each year for five years as follows:

Sales			$	4,000,000
Variable expenses				1,840,000
Contribution margin				2,160,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	760,000
Depreciation		820,000
Total fixed expenses				1,580,000
Net operating income			$	580,000

Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using tables.

Required:

1. What is the project’s net present value?

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

3. What is the project’s simple rate of return?

4-a. Would the company want Casey to pursue this investment opportunity?

4-b. Would Casey be inclined to pursue this investment opportunity?

Answer 1

NPV
Annual Inflows:
Net income			580000
Add: Depreciation			820000
Annual Inflows:			1400000
Annuity PVF at 19% for 5yrs			3.05763
Present value of inflows			4280682
Less: Initial Investment			-4100000
NPV			180682
IRR:
Annual Inflows:
Net income			580000
Add: Depreciation			820000
Annual Inflows:			1400000
Annuity PVF at 20.95% for 5yrs			2.92916
Present value of inflows			4100824
Less: Initial Investment			-4100000
NPV			824
Hence, IRR = 20.95%
Accounting rate of return:
Net Income				580000
Divide: Average investment (4100000/2)				2050000
Accounting rate of return:				28.29%
Yes, Company shall pursue this investment
Yes, Casey shll be inclined to continue this investment