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 $3,080,000 investment in equipment with a useful life of five years and no salvage value. Holston Company's discount rate is 17%. The project would provide net operating income each year for five years as follows: Sales Variable expenses Contribution margin Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs $ 620,000 616,000 $ 2,700,000 1,100,000 1,600,000 Depreciation Total fixed expenses Net operating income Click here to view Exhibit 128-1 and Exhibit 128-2. to determine the appropriate discount factor(s) using tables. 1,236,000 $364,000 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?
Net Present Value
Net present value is the most important concept of finance. It is used to evaluate the investment and financing decisions that involve cash flows occurring over multiple periods. The difference between the present value of cash inflow and cash outflow is termed as net present value (NPV). It is used for capital budgeting and investment planning. It is also used to compare similar investment alternatives.
Investment Decision
The term investment refers to allocating money with the intention of getting positive returns in the future period. For example, an asset would be acquired with the motive of generating income by selling the asset when there is a price increase.
Factors That Complicate Capital Investment Analysis
Capital investment analysis is a way of the budgeting process that companies and the government use to evaluate the profitability of the investment that has been done for the long term. This can include the evaluation of fixed assets such as machinery, equipment, etc.
Capital Budgeting
Capital budgeting is a decision-making process whereby long-term investments is evaluated and selected based on whether such investment is worth pursuing in future or not. It plays an important role in financial decision-making as it impacts the profitability of the business in the long term. The benefits of capital budgeting may be in the form of increased revenue or reduction in cost. The capital budgeting decisions include replacing or rebuilding of the fixed assets, addition of an asset. These long-term investment decisions involve a large number of funds and are irreversible because the market for the second-hand asset may be difficult to find and will have an effect over long-time spam. A right decision can yield favorable returns on the other hand a wrong decision may have an effect on the sustainability of the firm. Capital budgeting helps businesses to understand risks that are involved in undertaking capital investment. It also enables them to choose the option which generates the best return by applying the various capital budgeting techniques.
![Exercise 12-9 (Algo) Net Present Value Analysis and Simple Rate of Return [LO12-2, LO12-6]
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 $3,080,000 investment in equipment with a useful life of five years and no salvage value. Holston Company's discount rate is
17%. The project would provide net operating income each year for five years as follows:
Sales
Variable expenses
Contribution margin
Fixed expenses
Advertising, salaries, and other fixed
out-of-pocket costs
$620,000
616,000
$ 2,700,000
1,100,000
1,600,000
Depreciation
Total fixed expenses
Net operating income
Click here to view Exhibit 128-1 and Exhibit 128-2, to determine the appropriate discount factor(s) using tables.
1,236,000
$364,000
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?](/v2/_next/image?url=https%3A%2F%2Fcontent.bartleby.com%2Fqna-images%2Fquestion%2Fa38b5e28-cb00-43f4-9314-fa9d142d87fc%2F4cc1485d-d079-4123-97df-64c600158597%2F3yshxbf_processed.jpeg&w=3840&q=75)
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