Question

Lizzy, a strategic planner at Wild Products, is trying to decide which product to make and sell over the next 5 years. Lizzy gets a raise based on her company’s Return on Investment which has been more that 18% in the last 3 years. Below are the cost and revenue projections for each product:

Discount rate: 16%

                                                                                                                Gadgets                                               Widgets

Initial Investment:                                                                          

Cost of Equipment (zero salvage value)                                  $170,000                                              $380,000             

Annual revenues and costs:

Sales Revenue                                                                                  $250,000                                              $350,000

Variable Expenses                                                                           $120,000                                              $170,000

Depreciation Expense                                                                    $34,000                                                 $76,000

Fixed out-of-pocket operating costs                                         $70,000                                                 $50,000

Requirements

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
6. Indicate which product is preferable based on each of the above metrics
7. Which, if any, product should Lizzy pursue and why?

Answer 1

1. The payback period refers to the amount of time it takes to recover the cost of an investment.

2. Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.

3. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.

4. A simple rate of return is how much a company expects to make off of a capital investment every year. Calculating the simple rate of return is just as straightforward as you'd imagine. Simply divide the expected yearly profit of the upgrade by the total cost of the upgrade.

We calculate the operating cashflow each year expected from each product each year

Operating Cash flow = (Sales - Variable cost - Fixed Cost - Depreciation - Op Exp ) (1- Tax Rate) + Depreciation

Widgets= (350000 - 170000 - 76000 - 50000)( 1 - 0.30) + 76000 = 113,800

Gadgets= (250,000 - 120000 - 34000 - 70000) (1-0.30) + 34000 = 52200

In absence of info we asume tax rate to be 30%

1) Payback period= Initial Investment / Cashflow each year

widgets = 380000 / 113800 = 3.34 years

Gadgets = 170000 / 52200 = 3.26 years

Based on payback, gadgets should be selected

2) Net Present Value = PV of cash inflow - Initial Investment

Widgets = 113800 * (PVAF 16%, 5 Years) - 380000 = 113800 * 3.2743 - 380000 = -7385

Gadgets = 52200 *(PVAF 16%, 5 Years) - 170000 = 5200 * 3.2743 - 170000 = 918.46

3) IRR ; PVCI = Initial Investment

Widgets : 113800* PVAF = 380000; PVAF = 3.3392 i.e Interest Rate of 15.16%, we get PVAF of 3.3392

Gadgets : 52200* PVAF = 170000 : PVAF = 3.2567 i.e Interest Rate of 16.23%, we get PVAF of 3.2567

Based on IRR, project gadgets should be selected as IRR is more than required rate of return.

4) Simple Rate of Return = Net Operating Income / Initial Investment

We have calculated operating cashflow above, there if we dont add back depreciation, we get operating income

Widgets = 113800 - 76000 = 37800

Gadgets = 52200 - 34000 = 18200

Simple Return:

Widgets = 37800 / 380000 = 9.95%

Gadgets = 18200 / 170000 = 10.71%

Based on Simple Return, Gadgets should be selected.

5) Based on all the methods, NPV method is the best method to evaluate. Based on which gadgets should be selected, as NPV is positive at required return of 16%. We should look at the required return to evaluate the project and not based on past rate of return which is basis for lizzys bonus evaluation.