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: Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using tables. Required: 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.) Net present value 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%.) Simple rate of return % Would the company want Derrick to pursue this investment opportunity? Yes No Would Derrick be inclined to pursue this investment opportunity? Yes No

Explanation / Answer

Solution:- (1) NPV= Present value of cash inflow - present value of cash outflow
present value of cash outflow(PVCO)= $3,200,000
Annual cash inflow = Net operating income+Depreciation
= 430,000+610,000 = $1,040,000
Present value of cash inflow(PVCI)= Annual cash inflow*PVAF(r,n)
   =$1,040,000*PVAF(18%,5 years)
   = 1,040,000 *3.127 = $3,252,080

NPV=PVCI-PVCO = $(3,252,080- 3,200,000) = $52,080

(2) Simple rate of return= (Average income/original investment)*100

=(430,000/3,200,000)*100 = 13.4%

(3-a) As NPV of the project is positive so the company want Derrick to persue this investment opportunity, therefore the answer is YES

(3-b) As Derrick division rate of return from last three years is 20% but the current project rate of return is around 13.4% which is much more lower than his past reurns so Derrick will not inclined to persue this investment opportunity so Answer is NO.

  

     

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