Casey Nelson is a divisional manager for Pigeon Company. His annual pay raises a
ID: 2544744 • 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
Answer 1. Year Now 1 2 3 4 5 Purchase of Equipment (3,500,000) - - - - - Sales 3,400,000 3,400,000 3,400,000 3,400,000 3,400,000 Variable Expenses (1,600,000) (1,600,000) (1,600,000) (1,600,000) (1,600,000) Out of Pocket Costs (700,000) (700,000) (700,000) (700,000) (700,000) Total Cash Flow (3,500,000) 1,100,000 1,100,000 1,100,000 1,100,000 1,100,000 Discount Factor - 16% 1.00000 0.86207 0.74316 0.64066 0.55229 0.47611 Present Value (3,500,000) 948,276 817,479 704,723 607,520 523,724 NPV 101,723 Answer 2. Simple Rate of return = Annual Incremental Net Operating Income / Intial Investment Simple Rate of return = $400,000 / $3,500,000 Simple Rate of return = 11.43% (Approx.) Answer 3. Accept the Project