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)	$	370,000		$	570,000
Annual revenues and costs:
Sales revenues	$	400,000		$	480,000
Variable expenses	$	182,000		$	214,000
Depreciation expense	$	74,000		$	114,000
Fixed out-of-pocket operating costs	$	88,000		$	68,000

  

The company’s discount rate is 20%.

I have solved the following:

1. Calculate the payback period for each product. - Product A = 2.85 Product B = 2.88

2. Calculate the net present value for each product. - Product A = $18,830 Product B = $22,218

Having trouble trying to solve these:

3. Calculate the internal rate of return for each product. (Round percentage answers to 1 decimal place. i.e. 0.1234 should be considered as 12.3% and round discount factor(s) to 3 decimal places.)

4. Calculate the project profitability index for each product. (Round discount factor(s) to 3 decimal places. Round your answers to 2 decimal places.)

5. Calculate the simple rate of return for each product. (Round percentage answers to 1 decimal place. i.e. 0.1234 should be considered as 12.3%.)

6a. For each measure, identify whether Product A or Product B is preferred.

Answer 1

Solution 1:

Computation of Annual cash inflows
Particulars	Product A	Product B
Sales revenue	$400,000.00	$480,000.00
Variable expenses	$182,000.00	$214,000.00
Fixed Out of pocket operating cost	$88,000.00	$68,000.00
Annual cash inflows	$130,000.00	$198,000.00

Payback period
Particulars	Choose Numerator	/	Choose Denominator	=	Payback Period
	Initial Investment	/	Annual Cash inflows	=	Payback Period
Product A	$370,000.00	/	$130,000.00	=	2.85	Years
Product B	$570,000.00	/	$198,000.00	=	2.88	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	$370,000	$370,000	$570,000	$570,000
Present Value of Cash outflows (A)				$370,000		$570,000
Cash Inflows
Annual cash inflows	1-5	2.99100	$130,000	$388,830	$198,000	$592,218
Present Value of Cash Inflows (B)				$388,830		$592,218
Net Present Value (NPV) (B-A)				$18,830		$22,218

Solution 3:

Computation of IRR
Period	Product A		Product B
	Cash Flows	IRR	Cash Flows	IRR
0	-$370,000.00	22.3%	-$570,000.00	21.8%
1	$130,000.00		$198,000.00
2	$130,000.00		$198,000.00
3	$130,000.00		$198,000.00
4	$130,000.00		$198,000.00
5	$130,000.00		$198,000.00

Solution 4:

Computation of Profitability Index
Particulars	Product A	Product B
Present value of cash inflows	$388,830	$592,218
Initial investment	$370,000	$570,000
Profitability Index (PV of cash inflows / Initial investment)	1.05	1.04

Solution 5:

Computation of Annual Operating income
Particulars	Product A	Product B
Annual cash inflows	$130,000.00	$198,000.00
Less: depreciation	$74,000.00	$114,000.00
Annual operating income	$56,000.00	$84,000.00

Simple rate of return
Particulars	Choose Numerator	/	Choose Denominator	=	Simple rate of return
	Annual operating income	/	Initial investment	=	Simple rate of return
Product A	$56,000.00	/	$370,000.00	=	15.1%
Product B	$84,000.00	/	$570,000.00	=	14.7%

Solution 6:

Product Preference
Payback Period	Product A
Net Present Value	Product B
IRR	Product A
Profitability index	Product A
Simple rate of return	Product A