Question

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 20% each of the last three years. casey is considering a capital budgeting project that would require a $3,500,000 investment in equipment with a useful life of five years and no salvage value. pigeon company's discount rate is 16%. all sales are collected in cash, all variable expenses are paid in cash during the year they are incurred, and all out-of-pocket fixed expenses are paid in cash during the year they are incurred. the project would provide net operating income each year for five years as follows:

Answer 1

Answer:

1. Net Present Value

Annual Cash flow = Net operating income + depreciation

= 550000+800000 = 1,350,0000

Present value annuity factor at 19% for 5 years = 3.058

NPV = (3.058x 1,350,000 ) - 3500000  = 628300

2. IRR

IRR is the rate at which NPV will become zero

hence PVAF at R % ,5 years x 1,350,000= 3500000

PVAF at R %, 5 years = 2.59

From the Present value annuity factor table in 5 year raw at 20% we will get 2.991

NPV at 20% = 2.991 x 13,50,000-40,00,000 = 37850

Now take PVAF at 21% from table (We want to get lesser NPV, so taking the next highest percentage from the table)

NPV at 21 % = 2.926 x 1350000-40,00,000=49900

So, IRR = 20% + (37850/37850+49900) x 1%

= 20.43%

3. Simple rate of return

Rate of return = Average net operating income / average investment

= 550000/4000000

= 13.75%

Answer 2

Answer:

a. Compute the project's net present value.

• NPV = -$553,135.71

b. Compute the project's internal rate of return.

• 9.01%

Explanation:

we need to calculate the net cash flows = net operating income + depreciation expense = $300,000 + $600,000 = $900,000

now we need to determine the net present value (NPV):

• initial investment  -$3,500,000
• CF1                            $900,000
• CF2                           $900,000
• CF3                           $900,000
• CF4                           $900,000
• CF5                           $900,000

Using an excel spreadsheet and the NPV function with  16% discount rate:

NPV = discounted cash flows - initial investment = $2,946,864.29

- $3,500,000 = -$553,135.71

We can also calculate the internal rate of return using excel and the IRR function:

IRR = 9.01%