Casey Nelson is a divisional manager for Pigeon Company. His annual pay raises a
ID: 2393917 • Letter: C
Question
Casey Nelson is a divisional manager for Pigeon Company. His annual pay raises are largely determined by his division's return on investment (ROI), which has been above 23% each of the last three years. Casey is considering a capital budgeting project that would require a $4,100,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company's discount rate is 19%, The project would provide net operating income each year for five years as follows: Variable expenses Contribution margin Fixed expenses: $ 4,000, 000 1, 840, 000 2, 160, 000 int Advertising, salaries, and other fixed out-of-pocket costs Depreciation $760, 000 820,0001.580,000 Total fixed expenses Net operating income Click here to view Exhibit 13B-1 and Exhibit 138-2, to determine the appropriate discount factor(s) using tables. Required 1. What is the project's net present value? 2. What is the project's internal rate of return to the nearest whole percent? 3. What is the project's simple rate of return? 4-a. Would the company want Casey to pursue this investment opportunity? 4-b. Would Casey be inclined to pursue this investment opportunity?Explanation / Answer
1.
Investment in the project = $4,100,000
Annual operating income = $580,000
Annual depreciation = $820,000
Hence, annual cash inflows = 580,000 + 820,000
= $1,400,000
Present value of cash inflows = Annual cash inflows x PVAF(19% , 5 )
= 1,400,000 x 3.058
= $4,281,200
Net present value = Present value of cash inflows - Present value of cash outflows
= 4,281,200 - 4,100,000
= $181,200
2.
To find out Internal rate of return, a higher discount rate may be considered where NPV becomes zero. Let us discount the cash inflows at 21%
Present value of cash inflows (at 21% discount rate) = Annual cash inflows x PVAF( 21% , 5 )
= 1,400,000 x 2.926
= -$4,096,400
NPV (at 21%) = Present value of cash inflows - Present value of cash outflows
= 4,096,400 - 4,100,000
= -$3,600
Internal rate of return is the rate at which NPV of a project becomes zero. Since the question is asking to find out Internal rate of return to the nearest whole percent, hence Internal rate of return of the project may be taken to be 21% although it is not exact. Exact IRR of the project will be marginally below 21%
3.
Project's simple rate of return = Net operating income/Investment in the project
= 580,000/4,100,000
= 14.15%
4a.
Since the project's Internal rate of return is more than the company's required rate of return, hence company would want Casey to undertake this project.
4b.
Since, Casey's pay raises are directly affected by division's return on investment, hence Casey would not be interested in undertaking this project since annual returns on this project (14.15%) are less than the division's return on investment (23%)