Casey Nelson is a divisional manager for Pigeon Company. His annual pay raises a
ID: 2541241 • 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%. The project would provide net operating income each year for the five years as follows:
Sales...... ..................$3,400,000
Variable Expenses...1,600,000
Contribution Margin...1,800,000
Fixed Expenses:
Advertising, salaries, & other fixed out of pocket costs.... $700,000
Depreciation.......................................................................700,000
Total FIxed Expenses...................................................................................1,400,000
Net Operating income...................................................................................$400,000
Problem 11-13A
1. The net present value is computed as follows:
Now
1
2
3
4
5
Purchase of equipment...............
Sales........................
Variable expenses.....
Out-of-pocket costs.
__________
Total cash flows (a)..
Discount factor (b)...
Present value (a)×(b)................................
Net present value.....
2. The simple rate of return is computed as follows:
3. The company would want Casey to
Now
1
2
3
4
5
Purchase of equipment...............
Sales........................
Variable expenses.....
Out-of-pocket costs.
__________
Total cash flows (a)..
Discount factor (b)...
Present value (a)×(b)................................
Net present value.....
Explanation / Answer
Req 1 NET PRESENT VALUE NOW YEAR1 YEAR2 YEAR3 YEAR4 YEAR5 Purchase of equipment -3,500,000 sales 3,400,000 3,400,000 3,400,000 3,400,000 3,400,000 Vvariable expense 1600000 1600000 1600000 1600000 1600000 Out of pocket cost 700000 700000 700000 700000 700000 Total cash flows -3,500,000 1100000 1,100,000 1,100,000 1,100,000 1,100,000 Discount factor 1 0.862069 0.743163 0.640658 0.552291 0.476113 Present value -3500000 948275.9 817479.2 704723.4 607520.2 523724.3 Net present value 101,723 Req 2: Annual operating profits: Sales 3,400,000 Less: Variable cost 1,600,000 Less: Total fixed cost 1,400,000 Net operating income 400,000 Average Investment: 1,750,000 (i.e. 3500,000/2) Rate of return: Average annual income / average investment *100 ($ 400,000 /1750,000 *100 ) = 22.86% Req 3: The Company would want casey to Invest in project.