Question

Lou Barlow, a divisional manager for Sage Company, has an opportunity to manufacture and sell one of two new products for a five-year period. His annual pay raises are determined by his division’s return on investment (ROI), which has exceeded 22% each of the last three years. He has computed the cost and revenue estimates for each product as follows: Product A Product B Initial investment: Cost of equipment (zero salvage value) $ 380,000 $ 575,000 Annual revenues and costs: Sales revenues $ 410,000 $ 490,000 Variable expenses $ 186,000 $ 218,000 Depreciation expense $ 76,000 $ 115,000 Fixed out-of-pocket operating costs $ 89,000 $ 70,000 The company’s discount rate is 20%. Click here to view Exhibit 12B-1 and Exhibit 12B-2, to determine the appropriate discount factor using tables. Required: 1. Calculate the payback period for each product. 2. Calculate the net present value for each product. 3. Calculate the internal rate of return for each product. 4. Calculate the project profitability index for each product. 5. Calculate the simple rate of return for each product. 6a. For each measure, identify whether Product A or Product B is preferred. 6b. Based on the simple rate of return, Lou Barlow would likely:

please show all steps

Answer 1

Solution 1:
	Computation of Annual cash inflows
	Particulars	Product A	Product B
	Sales revenue	$4,10,000	$4,90,000
	Variable expenses	$1,86,000	$2,18,000
	Fixed Out of pocket operating cost	$89,000	$70,000
	Annual cash inflows	$1,35,000	$2,02,000
Payback period
Particulars	Choose Numerator	/	Choose Denominator	=	Payback Period
	Initial Investment	/	Annual Cash inflows	=	Payback Period
Product A	$3,80,000	/	$1,35,000	=	2.81	Years
Product B	$5,75,000	/	$2,02,000	=	2.85	Years
Solution 2:
Computation of NPV
			Product A	Product B
Particulars	Period	PV Factor (20%)	Amount	Present Value	Amount	Present Value
Cash outflows:
Initial investment	0	1	$3,80,000	$3,80,000	$5,75,000	$5,75,000
Present Value of Cash outflows (A)				$3,80,000		$5,75,000
Cash Inflows
Annual cash inflows	1-5	2.991	$1,35,000	$4,03,785	$2,02,000	$6,04,182
Present Value of Cash Inflows (B)				$4,03,785		$6,04,182
Net Present Value (NPV) (B-A)				$23,785		$29,182
Solution 3:
Computation of IRR
	Project A		Project B
Period	Cash flows	IRR	Cash flows	IRR
0	-$3,80,000	22.8%	-$5,75,000	22.3%
1	$1,35,000	$2,02,000
2	$1,35,000	$2,02,000
3	$1,35,000	$2,02,000
4	$1,35,000	$2,02,000
5	$1,35,000	$2,02,000
Solution 4:
Computation of Profitability Index
Particulars	Product A	Product B
Net present value	$23,785	$29,182
Initial investment	$3,80,000	$5,75,000
Profitability Index (PV of cash inflows / Initial investment)	0.06	0.05