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 23% each of the last three years. Casey is considering a capital budgeting project that would require a $5,380,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company’s discount rate is 19%. 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?

Solution

Solution 1:

Annual cash flows = Operating income + Depreciation = $724,000 + $1,076,000 = $1,800,000

Solution 2:

Solution 3:

Project simple rate of return = Net operating income / Initial investment = $724,000 / $5,380,000 = 13.46%

Solution 4a:

As IRR offered by project is 20% which is higher than required return of the company, therefore company want Casey to pursue this investment opportunity.

Solution 4b:

Casey do not want to pursue this investment opportunity as ROI offered by investment is lesser than 23%, therefore it will decrease overall ROI of the division.