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)	$	350,000		$	550,000
Annual revenues and costs:
Sales revenues	$	390,000		$	470,000
Variable expenses	$	178,000		$	210,000
Depreciation expense	$	70,000		$	110,000
Fixed out-of-pocket operating costs	$	87,000		$	67,000

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.

Answer 1

Annual cash flows:
			Product A	ProductB
Sales revenue			390000	470000
Less: variable cost			178000	210000
Less: Out of pocket fixed cost			87000	67000
Annual cashflows			125000	193000
Payback period:
Initial investment			350000	550000
Divide: Annual Cashflows			125000	193000
Payback period:			2.8	2.85
Req 2.
Annual Cashflws			125000	193000
Annuity PVF at 20% for5yrs			2.99061	2.99061
Present value of Cashflows			373826.3	577187.73
Less: Intial Investment			350000	550000
NPV			23826.3	27187.73
Req 3.
Annual Cashflws			125000	193000
Annuity PVF at 23.05% for5yrs			2.80052
Annuity PVF at 22.25% for5yrs				2.8484
Present value of Cashflows			350065	549741.2
Less: Intial Investment			350000	550000
NPV			65	-258.8
IRR			23.05%	22.25%
Req 4.
Profitab ility Index:
Present value of inflows at 20%			373826.3	577187.73
Divide: Inintial Investment			350000	550000
Profitab ility Index:			1.07	1.05