Derrick Iverson is a divisional manager for Holston Company

Derrick Iverson is a divisional manager for Holston 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. Derrick is considering a capital budgeting project that would require a $4,450,000 investment in equipment with a useful life of five years and no salvage value. Holston Company’s discount rate is 18%. The project would provide net operating income each year for five years as follows:

Derrick Iverson is a divisional manager for Holston 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. Derrick is considering a capital budgeting project that would require a $4,450,000 investment in equipment with a useful life of five years and no salvage value. Holston Company’s discount rate is 18%. The project would provide net operating income each year for five years as follows:

Sales $ 3,800,000 Variable expenses 1,650,000 Contribution margin 2,150,000 Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs S710,000 710,000 Total fixed expenses 1,420,000 Net operating income $ 730,000 Use Excel or a financial calculator to solve. Required: 1. Compute the project\'s net present value to the nearest dollar. 2. Compute the project\'s simple rate of return. (Round your answer to 1 decimal place. L.e. 0.123 should be considered as 12.3%.) 3-a. Would the company want Derrick to pursue this investment opportunity? O Yes O No 3-b. Would Derrick be inclined to pursue this investment opportunity? O Yes O No

Solution

(1). Project’s Net Present Value = $ 53,126

Annual Cash flow = Net Operating Income + Depreciation

= $730,000 + 710,000

= $14,40,000

Net present value (NPV) = Present Vale of cash flows – Initial Investments

= [$14,40,000 x (PVIFA 18%,5Years) ] - $44,50,000

= [$14,40,000 x 3.127171021] - $44,50,000

= $ 4,503,126 - 4,450,000

= $ 53,126

(2) Project’s simple rate of return = 16.4%

Simple rate of Return = [Net Operating Income / Investment] x 100

= [$730,000 / 44, 50,000] x 100

= 16.4%

3(a) - Would the company want Derrick to pursue this investment opportunity = YES

3(b) - Would Derrick be inclined to pursue this investment opportunity = YES