Casey Nelson is a divisional manager for Pigeon Company. His annual pay raises a
ID: 2413639 • 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 $5,380,000 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:
Click here to view Exhibit 13B-1 and Exhibit 13B-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?
Sales $ 4,800,000 Variable expenses 2,160,000 Contribution margin 2,640,000 Fixed expenses: Advertising, salaries, and otherfixed out-of-pocket costs $ 840,000 Depreciation 1,076,000 Total fixed expenses 1,916,000 Net operating income $ 724,000
Explanation / Answer
Solution 1:
Annual cash flows = Operating income + Depreciation = $724,000 + $1,076,000 = $1,800,000
Solution 2:
Solution 3:
Project simple rate of return = Net operating income / Initial investment = $724,000 / $5,380,000 = 13.46%
Solution 4a:
As IRR offered by project is 20% which is higher than required return of the company, therefore company want Casey to pursue this investment opportunity.
Solution 4b:
Casey do not want to pursue this investment opportunity as ROI offered by investment is lesser than 23%, therefore it will decrease overall ROI of the division.
Computation of NPV - Pigeon Company Particulars Amount Period PV Factor Present Value Cash Outflows: Cost of Investment $5,380,000.00 0 1 $5,380,000.00 Present Value of Cash Outflows (A) $5,380,000.00 Cash Inflows: Annual cash inflows $1,800,000.00 1-5 3.05763 $5,503,742.80 Present Value of Cash Inflows (B) $5,503,742.80 Net Present Value (B-A) $123,742.80