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 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

Fisrt we have to find the annual cash inflow of each product. Depreciation is an non cash item and thus ignored for calculation.

1. Calculate the payback period for each product.

Product A preferred

2. Calculate the net present value for each product.

Product B preferred

3. Calculate the internal rate of return for each product.

IRR is the rate at which NPV = $0. In the given table two discounting factors are used. With a 4% difference in discounting factors, NPV changed by $32,941. So we need to find the change required for $7,955. Let Z be the change in discounting rate required.

This can be formulated as ($32,941/ 4%) = ($7,955 / Z%)

Z% = 1.10%

IRR Product A= 22% + 1.05% = 23.05%

IRR is the rate at which NPV = $0. In the given table two discounting factors are used. With a 4% difference in discounting factors, NPV changed by $50,862. So we need to find the change required for $2,682. Let Z be the change in discounting rate required.

This can be formulated as ($50,862/ 4%) = ($2,682 / Z%)

Z% = 0.22%

IRR Product B= 22% + 0.22% = 22.22%

Product A preferred

4. Calculate the project profitability index for each product.

Product A preferred

5. Calculate the simple rate of return for each product.

Simple rate of return will include depreciation expense also

Product A preferred

6b. Based on the simple rate of return, Lou Barlow would likely: Prefer product A