Casey Nelson is a divisional manager for Pigeon Company. His annual pay raises a
ID: 2787328 • 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 $5,050,000 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:
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?
I just need help on question 1,2,3.
Sales $ 4,700,000 Variable expenses 2,120,000 Contribution margin 2,580,000 Fixed expenses: Advertising, salaries, and otherfixed out-of-pocket costs $ 830,000 Depreciation 1,010,000 Total fixed expenses 1,840,000 Net operating income $ 740,000
Explanation / Answer
1.
Annual Cash Flow = Net Operating Income + Depreciation Annual Cash Flow
= $ 470,000 + $ 1,010,000 = $ 1,750,000
Year
Cash Flow
PV Factor Formula
PV Factor @ 20 %
PV
0
$ (5,050,000)
1/(1+0.20)^0
1.00000
$ (5,050,000.00)
1
$ 1,750,000
1/(1+0.20)^1
0.83333
$ 1,458,333.33
2
$ 1,750,000
1/(1+0.20)^2
0.69444
$ 1,215,277.78
3
$ 1,750,000
1/(1+0.20)^3
0.57870
$ 1,012,731.48
4
$ 1,750,000
1/(1+0.20)^4
0.48225
$ 843,942.90
5
$ 1,750,000
1/(1+0.20)^5
0.40188
$ 703,285.75
NPV
$ 183,571.24
2.
Let us compute IRR using trial and error method.
Let us try with 21 %.
Year
Cash Flow
PV Factor Formula
PV Factor @ 21 %
PV
0
$ (5,050,000)
1/(1+0.21)^0
1.00000
$ (5,050,000.00)
1
$ 1,750,000
1/(1+0.21)^1
0.82645
$ 1,446,280.99
2
$ 1,750,000
1/(1+0.21)^2
0.68301
$ 1,195,273.55
3
$ 1,750,000
1/(1+0.21)^3
0.56447
$ 987,829.38
4
$ 1,750,000
1/(1+0.21)^4
0.46651
$ 816,387.92
5
$ 1,750,000
1/(1+0.21)^5
0.38554
$ 674,700.76
NPV
$ 70,472.59
AS NPV is positive let us try with 22 %
Year
Cash Flow
PV Factor Formula
PV Factor @ 22 %
PV
0
$ (5,050,000)
1/(1+0.22)^0
1.00000
$ (5,050,000.00)
1
$ 1,750,000
1/(1+0.22)^1
0.81967
$ 1,434,426.23
2
$ 1,750,000
1/(1+0.22)^2
0.67186
$ 1,175,759.20
3
$ 1,750,000
1/(1+0.22)^3
0.55071
$ 963,737.05
4
$ 1,750,000
1/(1+0.22)^4
0.45140
$ 789,948.40
5
$ 1,750,000
1/(1+0.22)^5
0.37000
$ 647,498.69
NPV
$ (38,630.42)
IRR = R1 +NPV 1 x (R2-R1) % / (NPV1-NPV2)
=21% + $ 70,472.59 x (22-21) % / ($ 70,472.59 -(-38,630.42)
=21% + $ 70,472.59 x 1 % / ($ 70,472.59 + 38,630.42)
=21% + $ 704.7259/$ 109,103.01
= 21 % + 0.006459271
= 21 % + 0.64 %
=21.64%
3.
Simple rate of return = Net income /Investment
= $ 740,000/$ 5,050,000 = 0.146534653 or 14.65 %
Year
Cash Flow
PV Factor Formula
PV Factor @ 20 %
PV
0
$ (5,050,000)
1/(1+0.20)^0
1.00000
$ (5,050,000.00)
1
$ 1,750,000
1/(1+0.20)^1
0.83333
$ 1,458,333.33
2
$ 1,750,000
1/(1+0.20)^2
0.69444
$ 1,215,277.78
3
$ 1,750,000
1/(1+0.20)^3
0.57870
$ 1,012,731.48
4
$ 1,750,000
1/(1+0.20)^4
0.48225
$ 843,942.90
5
$ 1,750,000
1/(1+0.20)^5
0.40188
$ 703,285.75
NPV
$ 183,571.24