Exercise 13-9 Net Present Value Analysis and Simple Rate of Return [LO13-2, L013
ID: 2598425 • Letter: E
Question
Exercise 13-9 Net Present Value Analysis and Simple Rate of Return [LO13-2, L013-6] 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 $3,800,000 investment in equipment with a useful life of five years and no salvage value. Holston Company's discount rate is 16%. The project would provide net operating income each year for five years as follows: Sales Variable expenses Contribution margin Fixed expenses: $3,200,000 1,350,000 1,850,000 Advertising, salaries, and other fixed out-of-pocket costs Depreciation 670,000 670,000 1,340,000 $ 510,000 Total fixed expenses Net operating income Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factorfs) using tables. Requirecd 1. Compute the project's net present value 2. Compute the project's simple rate of return. 3a. Would the company want Derrick to pursue this investment opportunity? 3b. Would Derrick be inclined to pursue this investment opportunity?Explanation / Answer
Investment cost = $3,800,000 , Net operating Income = $510,000
Annual cash flows = Net operating Income + Depreciation = 510,000 + 670,000 = $1,180,000
PV of cash flows = 1,180,000 * PVAF(16% for 5 years) = 1,180,000 * 3.2743 = $3,863,674
1. NPV = PV of cash inflows - Investment cost = 3,863,674 - 3,800,000 = $63,674
2. Simple rate of return = (Average Net Income / Average Investment) * 100
Average Investment = 3,800,000 + 0 / 2 = $1,900,000
Rate of return = (510,000 / 1,900,000) * 100 = 26.84%
3. Yes the company would want Derrick to pursue this investment opportunity as it will generate a positive NPV.
4. Yes Derrick would be inclined to pursue this investment opportunity as it will give a ROI of 26.84% (more than 20%) which will lead to his annual pay raises. Also the NPV of the project is positive which indicates that the project is profitable.
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