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 $4,000,000 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 2,500,000
Variable expenses 1,000,000
Contribution margin 1,500,000

Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs: $600,000
Depreciation: 600,000

Total fixed expenses 1,200,000
Net operating income $300,000

a. Compute the project's net present value. (Round discount factor(s) to 3 decimal places.)
b. Compute the project's simple rate of return. (Round your answer to whole decimal place i.e. 0.123 should be considered as 12%)

Respuesta :

Answer:

a) -$1,053,400

b) 8% rounded

Explanation:

A)

We first calculate free cash flows

Free cash flow each year =  Net operating income + Depreciation

Free cash flow each year = 300,000 + 600,000 = $900,000

Annuity value for 16% discount factor for 5 years = 3.274 (viewed from a table)

Present value of cash flows = 900,000 * 3.274 = $2,946,600

NPV = 2946600 - 4000000 = -$1,053,400

B)

Simple rate of return = Operating Income / Initial outlay

ROR = 300,000 / 4,000,000 = 0.075 or 7.75% or 8% rounded

Hope that helps.