Derrick Iverson is a divisional manager for Holston Company. His annual pay rais

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 $3,050,000 investment in equipment with a useful life of five years and no salvage value. Holston Company's discount rate is 16%. The project would provide net operating income each year for five years as follows: Sales Variable expenses $2,600,000 1,050,000 Contribution margin Fixed expenses: 1,550,000 Advertising, salaries, and other fixed out-of-pocket costs Depreciation $600,000 600,000 Total fixed expenses 1,200,000 Net operating income $ 350,000 Click here to view Exhibit 11B-1 and Exhibit 11B-2, to determine the appropriate discount factor(s) using tables. Required: 1. Compute the project's net present value. (Use the appropriate table to determine the discount factor(s), intermediate calculations and final answer to the nearest dollar amount.) Net present value

Explanation / Answer

1.

Cash flows each year = Net operating income + Depreciation

= 350,000 + 600,000

= 950,000

PVAF of 16% for 5 years = 3.274

Present value of cash inflows = Cash inflows each year * PVAF

= 950,000 * 3.274

= 3,110,300

Present value of cash outflows = 3,050,000

Net present value = Present value of cash inflows - Present value of cash outflows

= 3,110,300 - 3,050,000

= 60,300

2.

Simple rate of return = Net operating income / Investment

= 350,000 / 3,050,000

= 11.5%

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