Casey Nelson is a divisional manager for Pigeon Company His

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%. All sales are collected in cash, all variable expenses are paid in cash during the year they are incurred, and all out-of-pocket fixed expenses are paid in cash during the year they are incurred. The project would provide net operating income each year for five years as follows:

  

   

  

   

  

  

Yes

No

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%. All sales are collected in cash, all variable expenses are paid in cash during the year they are incurred, and all out-of-pocket fixed expenses are paid in cash during the year they are incurred. The project would provide net operating income each year for five years as follows:

Annual Cash Inflows: Sales Variable Expenses Fixed Out-of-Pocket Expenses Depreciation Expense + Depreciation Expense Net Cash Inflows Per Year

Solution

Solution 1:

Solution 2 and 3:

Solution 4:

At IRR present value of cash inflows will be equal to investment amount, therefore

$1,100,000 * Cumulative PV Factor for 5 periods at IRR = $3,500,000

Cumulative PV Factor for 5 periods at IRR = 3.181818

From PV table:

This PV Factor falls between 17% and 18%

PV factor at 17% = 3.199346

PV factor at 18% = 3.127171

IRR = 17% + (3.199346 - 3.1818181) / (3.199346 - 3.127171)

= 17.24%

Solution 4a:

As NPV is positive and IRR is higher than company discount rate, therefore company want Casey to pursue this investment opportunity.

Computation of Annual cash inflows
Particulars	Amount
Sales	$3,400,000.00
Variable expenses	$1,600,000.00
Fixed out of pocket expenses	$700,000.00
Depreciation Expense	$700,000.00
Net operating Income	$400,000.00
Add: Depreciation	$700,000.00
Annual cash inflows per year	$1,100,000.00