Answer:
a. Project's net present value is $1,015,163.09
b. Simple rate of return is 15%
c. Yes. The reason is that the project has a positive net present value of $1,015,163.09.
d. No. The reason is that the simple rate of return of 15% obtained in part b is lower the division’s return on investment (ROI), which has been above 20% each of the last three years.
Explanation:
a. Compute the project's net present value.
To compute this, we first calculate the annual cash inflow as follows:
Annual cash inflow = Net operating income + Depreciation = $452,000 + $828,000 = $1,,280,000
Now, the project's net present value can be calculated using the formula for calculating the present of an ordinary annuity as follows:
PV = P * [{1 - [1 / (1 + r)]^n} / r] …………………………………. (1)
Where;
PV = Present value of the annual cash flow = ?
P = Annual cash inflow = $1,280,000
r = Discount rate = 17%, or 0.17
n = Equipment useful years = 5
Substitute the values into equation (1) to have:
PV = $1,280,000 * [{1 - [1 / (1 + 0.17)]^5} / 0.17]
PV = $4,095,163.09
Project's net present value = PV - Project's initial investment = $4,095,163.09 - $3,080,000 = $1,015,163.09
b. Compute the project's simple rate of return
This can be computed as follows:
Simple rate of return = Net operating income / Initial investment = $452,000 / $3,080,000 = 0.15, or 15%
c. Would the company want Derrick to pursue this investment opportunity?
Yes. The reason is that the project has a positive net present value of $1,015,163.09.
Note that had it been the net present value of the project was negative, the company would not want to Derrick to pursue this investment opportunity since the decision of the company is based on whether the project's NPV is positive or negative.
d. Would Derrick be inclined to pursue this investment opportunity?
No. The reason is that the simple rate of return of 15% obtained in part b is lower the division’s return on investment (ROI), which has been above 20% each of the last three years.
Pursuing this investment opportunity will therefore reduce the Overall ROI of the division and Derrick will not get annual pay raises if this happens.
