Casey Nelson is a divisional manager for Pigeon Company. His annual pay raises a
ID: 2455086 • 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 24% each of the last three years. Casey is considering a capital budgeting project that would require a $6,100,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company’s discount rate is 20%. The project would provide net operating income each year for five years as follows:
Sales $ 5,400,000
Variable expenses 2,400,000
Contribution margin 3,000,000
Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs $900,000
Depreciation 1,220,000
Total fixed expenses 2,120,000
Net operating income $ 880,000
Required: 1. What is the project’s net present value? (Round discount factor(s) to 3 decimal places.)
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? (Round percentage answer to 1 decimal place. i.e. 0.123 should be considered as 12.3%.)
Explanation / Answer
Annual Net Cash Inflow
= Net operating income + Depreciation
= $880,000 + 12,20,000
= $21,00,000
Requirement (1) – Net Present Value[NPV]
Net present value = Present value of the annual net cash flows- initial investment
= $21,00,000 [PVIFA 20%, 5 Years] - $61,00,000
= [$21,00,000 x 2.99061214] - $61,00,000
= $ 6,280,285.494 - 6,100,000
= $ 180,285.494 [Rounded to 3 decimal places]
Requirement (2) - Project’s internal rate of return [IRR]
Internal Rate of Return Factor = Net Initial Investment / Annual Cash Flow
= $61,00,000 / 21,00,000
= 2.904762
From the Present Value Annuity Factor Table, We can find that the discount rate (IRR) corresponding to the factor of 2.904762 for 5 Years Will be approximately 21.34%
Therefore, Project’s internal rate of return [IRR] = 21% [Rounded to the nearest whole percent]
Requirement (3) - Project’s simple rate of return
Simple rate of return = [Net Operating Income / Initial Investment] x 100
= [ $880,000 / 61,00,000 ] x 100
= 14.4% [Rounded to 1 decimal place]