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 13B-1 and Exhibit 13B-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

Particulars	Product A	Product B
Initial Investment	380000	575000
Calculation of Cash inflows
Sales	410000	490000
Less :
Variable Expenses	186000	218000
Fixed Out of pocket operating costs	89000	70000
cash Inflows	135000	202000
Pv Annuity factor for 5 years for 20%	2.9906	2.9906
PV of Cash Inflows	403731	604101
1).Pay back period(initial investment/cash inflows)	2.8148 years	2.8465 years
2).NPV(Pv of cash inflows - initial investment)	23731	29101
3).IRR	6.25%	5.06%
4).Profitability index(Pv of Future incash flows/Initial investment)	1.0624	1.0506
5).Simple rate of return(net earnings after tax/initial investment)	15.53%	21.91%

6a. Preference

Particulars	Product A	Product B	Preference
1).Pay back period(initial investment/cash inflows)	2.8148	2.8465	Product A
2).NPV(Pv of cash inflows - initial investment)	23731	29101.2	Product B
3).IRR	6.25%	5.06%	Product A
4).Profitability index(Pv of Future incash flows/Initial investment)	1.0625	1.0506	Product A
5).Simple rate of return(net earnings after tax/initial investment)	15.53%	21.91%	Product B

6b. Based on the simple rate of return, Lou Barlow would likely to Prefer Product B