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 $3,200,000 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 Sales Variable expenses Contribution margin Fixed expenses: $2,800,000 1,150,000 1,650,000 Advertising, salaries, and other fixed out-of-pocket costs Depreciation 610,000 640,000 61,250,000 $400,000 Total fixed expenses Net operating income 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 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:

Solution 2:

Simple rate of return = Net operating income / Initial investment = $400,000 / $3,200,000 = 12.50%

Solution 3a:

As there is NPV of $52,258 from the project, therefore company want Derrick to Pursue this investment opportunity.

Solution 3b:

Derrick do not want to pursue this investment opportunity as ROI of his division will decrease due to this investment opportunity as this investment opportunity offers ROI of 12.50% only.

Computation of Annual Cash Inflows Particualrs Amount Net Operating income $400,000.00 Add: Depreciation $640,000.00 Annual cash inflows $1,040,000.00

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