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 23% 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) $ 390,000 $ 585,000 Annual revenues and costs: Sales revenues $ 420,000 $ 500,000 Variable expenses $ 185,000 $ 222,000 Depreciation expense $ 78,000 $ 117,000 Fixed out-of-pocket operating costs $ 90,000 $ 70,000 The company’s discount rate is 21%. 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:

Answer 1

Project A:

Initial Investment = $390,000

Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $420,000 - $185,000 - $78,000 - $90,000
Annual Net Income = $67,000

Annual Net Cash flows = Annual Net Income + Depreciation
Annual Net Cash flows = $67,000 + $78,000
Annual Net Cash flows = $145,000

Project B:

Initial Investment = $585,000

Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $500,000 - $222,000 - $117,000 - $70,000
Annual Net Income = $91,000

Annual Net Cash flows = Annual Net Income + Depreciation
Annual Net Cash flows = $91,000 + $117,000
Annual Net Cash flows = $208,000

Answer 1.

Project A:

Payback Period = Initial Investment / Annual Net Cash flows
Payback Period = $390,000 / $145,000
Payback Period = 2.69 years

Project B:

Payback Period = Initial Investment / Annual Net Cash flows
Payback Period = $585,000 / $208,000
Payback Period = 2.81 years

Answer 2.

Project A:

Net Present Value = -$390,000 + $145,000 * PVA of $1 (21%, 5)
Net Present Value = -$390,000 + $145,000 * 2.9260
Net Present Value = $34,270

Project B:

Net Present Value = -$585,000 + $208,000 * PVA of $1 (21%, 5)
Net Present Value = -$585,000 + $208,000 * 2.9260
Net Present Value = $23,608

Answer 3.

Project A:

Let IRR be i%

$390,000 = $145,000 * PVA of $1 (i%, 5)
PVA of $1 (i%, 5) = 2.6897
Using table values, i = 25%

So, IRR is 25%

Project B:

Let IRR be i%

$585,000 = $208,000 * PVA of $1 (i%, 5)
PVA of $1 (i%, 5) = 2.8125
Using table values, i = 23%

So, IRR is 23%

Answer 4.

Product A:

Profitability Index = Net Present Value / Initial Investment
Profitability Index = $34,270 / $390,000
Profitability Index = 0.09

Product B:

Profitability Index = Net Present Value / Initial Investment
Profitability Index = $23,608 / $585,000
Profitability Index = 0.04

Answer 5.

Project A:

Simple Rate of Return = Annual Net Income / Initial Investment
Simple Rate of Return = $67,000 / $390,000
Simple Rate of Return = 17.18%

Project B:

Simple Rate of Return = Annual Net Income / Initial Investment
Simple Rate of Return = $91,000 / $585,000
Simple Rate of Return = 15.56%

Answer 6-a.

Net Present Value = Project A
Profitability Index = Project A    
Payback Period = Project A
Internal Rate of Return = Project A
Simple Rate of Return = Project A

Answer 6-b.

Based on the simple rate of return, Lou Barlow would not accept any project as simple rate of return is lower than the return on investment.