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 20% 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)	$	260,000		$	470,000
Annual revenues and costs:
Sales revenues	$	310,000		$	410,000
Variable expenses	$	144,000		$	194,000
Depreciation expense	$	52,000		$	94,000
Fixed out-of-pocket operating costs	$	76,000		$	58,000

The company’s discount rate is 18%.

Required:

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

2. Calculate the project profitability index for each product.

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

4a. For each measure, identify whether Product A or Product B is preferred.

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

4b. Based on the simple rate of return, Lou Barlow would likely:

a) Accept Product A b) Accept Product B c) Reject both products

Answer 1

Project A:

Initial Investment = $260,000

Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $310,000 - $144,000 - $52,000 - $76,000
Annual Net Income = $38,000

Annual Net Cash flows = Annual Net Income + Depreciation
Annual Net Cash flows = $38,000 + $52,000
Annual Net Cash flows = $90,000

Project B:

Initial Investment = $470,000

Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $410,000 - $194,000 - $94,000 - $58,000
Annual Net Income = $64,000

Annual Net Cash flows = Annual Net Income + Depreciation
Annual Net Cash flows = $64,000 + $94,000
Annual Net Cash flows = $158,000

Answer 1.

Project A:

Let IRR be i%

$260,000 = $90,000 * PVA of $1 (i%, 5)
PVA of $1 (i%, 5) = 2.8889
Using table values, i = 21.6%

So, IRR is 21.6%

Project B:

Let IRR be i%

$470,000 = $158,000 * PVA of $1 (i%, 5)
PVA of $1 (i%, 5) = 2.9747
Using table values, i = 20.2%

So, IRR is 20.2%

Answer 2.

Project A:

Net Present Value = -$260,000 + $90,000 * PVA of $1 (18%, 5)
Net Present Value = -$260,000 + $90,000 * 3.1272
Net Present Value = $21,448

Profitability Index = Net Present Value / Initial Investment
Profitability Index = $21,448 / $260,000
Profitability Index = 0.08

Project B:

Net Present Value = -$470,000 + $158,000 * PVA of $1 (18%, 5)
Net Present Value = -$470,000 + $158,000 * 3.1272
Net Present Value = $24,098

Profitability Index = Net Present Value / Initial Investment
Profitability Index = $24,098 / $470,000
Profitability Index = 0.05

Answer 3.

Project A:

Simple Rate of Return = Annual Net Income / Initial Investment
Simple Rate of Return = $38,000 / $260,000
Simple Rate of Return = 14.6%

Project B:

Simple Rate of Return = Annual Net Income / Initial Investment
Simple Rate of Return = $64,000 / $470,000
Simple Rate of Return = 13.6%

Answer 4-a.

Internal Rate of Return = Project A
Profitability Index = Project A    
Simple Rate of Return = Project A

Answer 4-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.