Casey Nelson is a divisional manager for Pigeon Company. His annual pay raises a
ID: 2496961 • 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 21% each of the last three years. Casey is considering a capital budgeting project that would require a $3,700,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company’s discount rate is 17%. 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.
Exhibit 13B-1:
Exhibit 13B-2:
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%.)
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 21% each of the last three years. Casey is considering a capital budgeting project that would require a $3,700,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company’s discount rate is 17%. The project would provide net operating income each year for five years as follows:
Explanation / Answer
Answer:
Projects annual cashflow = Net operating income + Depreciation = $460,000+$740,000 = $1,200,000
a)
2) IRR =
3) Simple rate of return = {(Inflows - Outflows)/Initial investment}/no of years
= (($6,000,000 - $3,700,000)/$3,700,000)/5 = ($2,300,000/$3,700,000)/5 = 12.43%
4)
a) yes, as the NPV is positive and also IRR is higher than the cost of capital.
b) As the ROI (that is simple rate of interest - 12.43%) is lower than the ROI required of 21%, Casey will not be inclined to pursue this investment.
Year Cash flows Discount factor @17% Discounted cashflow 0 -3700000 1 -3700000 1 1200000 0.855 1026000 2 1200000 0.731 877200 3 1200000 0.624 748800 4 1200000 0.534 640800 5 1200000 0.456 547200 NPV = 140000