Derrick Iverson is a divisional manager for Holston Company. His annual pay rais
ID: 2457191 • 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 25% each of the last three years. Derrick is considering a capital budgeting project that would require a $5,160,000 investment in equipment with a useful life of five years and no salvage value. Holston Company's discount rate is 18%. The project would provide net operating income each year for five years as follows: 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.) 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%.)Explanation / Answer
1
Calculation of Net Present value of the project:
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Net Operating income
$ 870,000
$ 870,000
$ 870,000
$ 870,000
$ 870,000
Add: Depreciation
$ 790,000
$ 790,000
$ 790,000
$ 790,000
$ 790,000
Cash Inflows
$ 1,660,000
$ 1,660,000
$ 1,660,000
$ 1,660,000
$ 1,660,000
Initial Investment
$ (5,160,000)
Net Cash Flows (CF)
$ (5,160,000)
$ 1,660,000
$ 1,660,000
$ 1,660,000
$ 1,660,000
$ 1,660,000
PVF (18%)
1.000
0.847
0.718
0.609
0.516
0.437
PV = CF *PVF
$ (5,160,000)
$ 1,406,020
$ 1,191,880
$ 1,010,940
$ 856,560
$ 725,420
Net Present Value = Sum of PVs
$ 30,820
2
Calculation of Simple Rate of Return:
Simple Rate of Return = Net Operating income / Initial Investment = 870000 / 5160000 =
16.9%
1
Calculation of Net Present value of the project:
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Net Operating income
$ 870,000
$ 870,000
$ 870,000
$ 870,000
$ 870,000
Add: Depreciation
$ 790,000
$ 790,000
$ 790,000
$ 790,000
$ 790,000
Cash Inflows
$ 1,660,000
$ 1,660,000
$ 1,660,000
$ 1,660,000
$ 1,660,000
Initial Investment
$ (5,160,000)
Net Cash Flows (CF)
$ (5,160,000)
$ 1,660,000
$ 1,660,000
$ 1,660,000
$ 1,660,000
$ 1,660,000
PVF (18%)
1.000
0.847
0.718
0.609
0.516
0.437
PV = CF *PVF
$ (5,160,000)
$ 1,406,020
$ 1,191,880
$ 1,010,940
$ 856,560
$ 725,420
Net Present Value = Sum of PVs
$ 30,820
2
Calculation of Simple Rate of Return:
Simple Rate of Return = Net Operating income / Initial Investment = 870000 / 5160000 =
16.9%
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