Casey Nelson is a divisional manager for Pigeon Company. His annual pay raises a
ID: 2411181 • 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 20% each of the last three years. Casey is considering a capital budgeting project that would require a $3,500,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company’s discount rate is 16%. All sales are collected in cash, all variable expenses are paid in cash during the year they are incurred, and all out-of-pocket fixed expenses are paid in cash during the year they are incurred. The project would provide net operating income each year for five years as follows:
Yes
No
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 20% each of the last three years. Casey is considering a capital budgeting project that would require a $3,500,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company’s discount rate is 16%. All sales are collected in cash, all variable expenses are paid in cash during the year they are incurred, and all out-of-pocket fixed expenses are paid in cash during the year they are incurred. The project would provide net operating income each year for five years as follows:
Annual Cash Inflows: Sales Variable Expenses Fixed Out-of-Pocket Expenses Depreciation Expense + Depreciation Expense Net Cash Inflows Per YearExplanation / Answer
Solution 1:
Solution 2 and 3:
Solution 4:
At IRR present value of cash inflows will be equal to investment amount, therefore
$1,100,000 * Cumulative PV Factor for 5 periods at IRR = $3,500,000
Cumulative PV Factor for 5 periods at IRR = 3.181818
From PV table:
This PV Factor falls between 17% and 18%
PV factor at 17% = 3.199346
PV factor at 18% = 3.127171
IRR = 17% + (3.199346 - 3.1818181) / (3.199346 - 3.127171)
= 17.24%
Solution 4a:
As NPV is positive and IRR is higher than company discount rate, therefore company want Casey to pursue this investment opportunity.
Computation of Annual cash inflows Particulars Amount Sales $3,400,000.00 Variable expenses $1,600,000.00 Fixed out of pocket expenses $700,000.00 Depreciation Expense $700,000.00 Net operating Income $400,000.00 Add: Depreciation $700,000.00 Annual cash inflows per year $1,100,000.00