Derrick Iverson is a divisional manager for Holston Company. His annual pay rais
ID: 2416327 • Letter: D
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 $3,080,000 investment in equipment with a useful life of five years and no salvage value. Holston Company’s discount rate is 17%. The project would provide net operating income each year for five years as follows:
Sales $ 2,700,000
Variable expenses 1,100,000
Contribution margin 1,600,000
Fixed expenses:
Advertising, salaries, and other fixed
out-of-pocket costs $620,000
Depreciation 620,000
Total fixed expenses 1,240,000
Net operating income $ 360,000
Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using tables.
Required:
1.
Compute the project's net present value. (Round discount factor(s) to 3 decimal places, intermediate calculations and final answer to the nearest dollar amount.)
2.
Compute the project's simple rate of return. (Round your answer to 1 decimal place. i.e. 0.123 should be considered as 12.3%.)
3-a. Would the company want Derrick to pursue this investment opportunity?
Yes
No
3-b. Would Derrick be inclined to pursue this investment opportunity?
Yes
No
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 $3,080,000 investment in equipment with a useful life of five years and no salvage value. Holston Company’s discount rate is 17%. The project would provide net operating income each year for five years as follows:
Sales $ 2,700,000
Variable expenses 1,100,000
Contribution margin 1,600,000
Fixed expenses:
Advertising, salaries, and other fixed
out-of-pocket costs $620,000
Depreciation 620,000
Total fixed expenses 1,240,000
Net operating income $ 360,000
Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using tables.
Required:
1.
Compute the project's net present value. (Round discount factor(s) to 3 decimal places, intermediate calculations and final answer to the nearest dollar amount.)
2.
Compute the project's simple rate of return. (Round your answer to 1 decimal place. i.e. 0.123 should be considered as 12.3%.)
3-a. Would the company want Derrick to pursue this investment opportunity?
Yes
No
3-b. Would Derrick be inclined to pursue this investment opportunity?
Yes
No
Explanation / Answer
Solution to Part 1 Calculation of Net Present Value Year Cash flow Present value @17% 0 (3,080,000) (3,080,000) 1 980,000 837,607 2 980,000 715,903 3 980,000 611,883 4 980,000 522,977 5 980,000 446,989 Net Present Value 55,359 Note 1 Annual cash flows Sales 2,700,000 Less: Variable costs (1,100,000) Contribution margin 1,600,000 Less: Fixed costs (620,000) Cash flow 980,000 Simple rate of return or Internal rate of return calculation (IRR) Solution to Part 2 Simple rate of return = Annual Income / Capital Invested = 360000/3080000 0.116883117 or 11.7% Solution to Part 3a IRR is that rate of return which makes NPV equal to Zero. Here, we calculate IRR using Goal seek function in excel. Discount rate 0.177794603 Year Cash flow Present value @17% 0 (3,080,000) (3,080,000) 1 980,000 832,064 2 980,000 706,459 3 980,000 599,815 4 980,000 509,270 5 980,000 432,393 Net Present Value 0 We get IRR = 17.8% Company's return on investment (given) = 20% Since, IRR is less than ROI, it is advised not to pursue this opportunity. Solution to Part 3b No, Derrick would not be inclined to pursue since, taking ups this project will result in lower Return on Investment (Presently ROI is 20%, if this project is taken up, it will result in IRR of 17.8% and Simple Rate of return of 11.7%.)
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