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 25% each of the last three years.

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 25% each of the last three years. Derrick is considering a capital budgeting project that would require a $5,160,000 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			$	4,400,000
Variable expenses				1,950,000
Contribution margin				2,450,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	790,000
Depreciation		1,032,000
Total fixed expenses				1,822,000
Net operating income			$	628,000

Required:

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

1.

The net present value is computed as follows:

		Now			Years 1-5
Purchase of equipment	$	(5,160,000	)
Sales				$	4,400,000
Variable expenses					(1,950,000	)
Out-of-pocket costs					(790,000	)
Total cash flows (a)	$	(5,160,000	)	$	1,660,000
Discount factor (18%)(b)		1.000			3.127
Present value (a) × (b)	$	(5,160,000	)	$	5,190,820
Net present value	$	30,820

2.

The simple rate of return would be:

Simple rate of return	=	Annual incremental net income
		Initial investment
	=	$628,000	=	12.2%
		$5,160,000

3.

The company would want Derrick to pursue the investment opportunity because it has a positive net present value of $30,820. However, Derrick might be inclined to reject the opportunity because its simple rate of return of 12.2% is well below his historical return on investment (ROI) of 25%. Derrick may be justifiably concerned that implementing this project would lower his ROI and his next pay raise.

Thanks