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 $4,120,000 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 Variable expenses Contribution margin Fixed expenses: $3,500,000 1,500,000 2,000,000 Advertising, salaries, and other fixed out-of-pocket costs Depreciation $ 690,000 690,000 Total fixed expenses Net operating income 1,380,000 $ 620,000 Click here to view Exhibit 13B-1 and Exhibit 138-2, to determine the appropriate discount factor(s) using tables. Required 1. Compute the project's net present value. 2. Compute the project's simple rate of return. 3a. Would the company want Derrick to pursue this investment opportunity? 3b. Would Derrick be inclined to pursue this investment opportunity?

Explanation / Answer

SOLUTION

(1) Net Present value-

Cash flows = Sales - Variable expense - Out of pocket costs

= $3,500,000 - $1,500,000 - $690,000 = $1,310,000

(2) Simple rate of return = Net operating income / Investment

= $620,000 / $4,120,000 = 15.05%

(3A) Yes, the company would want Derrick persue this investment opportunity.

(3B) Yes, Derrick would be inclined to persure this investmen opportunity.

Years Cash flow ($) (A) PV factor (B) Present value ($) (A*B) 1 1,310,000 0.854 1,118,740 2 1,310,000 0.730 956,300 3 1,310,000 0.624 817,440 4 1,310,000 0.533 698,230 5 1,310,000 0.456 597,360 Sum of cash flows 4,188,070 Initial investment 4,120,000 1 4,120,000 NPV 68,070

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