Simmons Company is a merchandiser with multiple store locations. One of its stor

Question

Simmons Company is a merchandiser with multiple store locations. One of its store managers is considering a shift in her store’s product mix in anticipation of a strengthening economy. Her store would invest $800,000 in more expensive merchandise (an increase in its working capital) with the expectation that it would increase annual sales and variable expenses by $400,000 and $250,000, respectively for three years. At the end of the three-year period, the store manager believes that the economic surge will subside; therefore, she will release the additional investment in working capital. The store manager’s pay raises are largely determined by her store’s return on investment (ROI), which has exceeded 22% each of the last three years. Click here to view Exhibit 13B-1 to determine the appropriate discount factor(s) using table.

1. Assuming the company’s discount rate is 16%, calculate the net present value of the store manager’s investment opportunity.

2. Calculate the annual margin, turnover, and return on investment (ROI) provided by the store manager’s investment opportunity.

3. Assuming that the company’s minimum required rate of return is 16%, calculate the residual income earned by the store manager’s investment opportunity for each of years 1 through 3.

4. Do you think the store manager would choose to pursue this investment opportunity? Do you think the company would want the store manager to pursue it? why?

5. Using a discount rate of 16%, calculate the present value of your residual incomes for years 1 through 3. Is your answer greater then, less than, or equal to the net present value that you computed in (1) above? why? Support your explanation with computations.

Explanation / Answer

Solution 1:

Solution 2:

Annual margin of investment opportunity = Net Income / Sales = $150,000 / $400,000 = 37.50%

Turnover of investment opportunity = Sales / Investment = $400,000 / $800,000 = 0.50

Return on investment = Margin * Turnover = 37.50% * 0.50 = 18.75%

Solution 3:

Annual income from investment opportunity = $400,000 - $250,000 = $150,000

Minimum required return = $800,000 * 16% = $128,000

Residual income for each year from year 1 through 3 = Annual income from investment opportunity - Minimum required return

= $150,000 - $128,000 = $22,000

Solution 4:

As store manager performance is based on ROI and ROI exceeded 22% for last 3 years, ROI offered by investment opportunity is lesser than 22%, it may result in decrease in overall ROI of the division therefore store manager would not pursue this investment opportunity.

As ROI offered by invesment opportunity is higher than minimum required return of the company, therefore company would want the store manager to pursue it.

Note: I have answered first 4 parts of the question as per chegg policy. Kindly post separate question for answer of remaining questions.

Computation of NPV - Simmons Company Particulars Period Amount PV Factor Present Value Cash outflows: Investment in working capital 0 $800,000 1 $800,000 Present value of cash outflows (A) $800,000 Cash Inflows: Annual cash inflows 1-3 $150,000 2.26542 $339,813 Release of working capital 3 $800,000 0.64623 $516,983 Present value of cash inflow (B) $856,796 NPV (B-A) $56,796

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