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 25% 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) $ 370,000 $ 530,000 Annual revenues and costs: Sales revenues $ 400,000 $ 510,000 Variable expenses $ 180,000 $ 250,000 Depreciation expense $ 74,000 $ 106,000 Fixed out-of-pocket operating costs $ 85,000 $ 72,000 The company’s discount rate is 19%. 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

Working Note 1: Calculation of Cash Flow after Taxes( CFAT)

Particulars	Product A	Product B
Sales	400000	510000
Less: Variable cost	180000	250000
Contribution	220000	260000
Less:Fixed Cost	85000	72000
Less: Depreciation	74000	106000
Profit Before Tax	61000	82000
Less: Tax	0	0
Add:Depreciation	74000	106000
CFAT	135000	188000

Answer 1.Calculation of Net Present Value

NPV=PV of cash inflows-PV of cash outflows

Procedure :

Step 1: Compute intial cash flowsi.e Capital expenditure & Working capital

Step 2: Compute incremental cashflows after taxes( CFAT)

Step3: Compute Terminal Flow:i.e amount expected to be realised at the end of prjects life.It will include net salvage value of capital assets & recovery of working capital

Step4: Calculate NPV

Calculation of Net Present Value of Product A

Year	Cash Flow	Amount	DF @19%	Discounted Cash Flow @ 19%
0	Cost of Equipement	-370000	1	-370000
1	CFAT (WN 1)	135000	0.8403	113441
2	CFAT (WN 1)	135000	0.7062	95337
3	CFAT (WN 1)	135000	0.5934	80109
4	CFAT (WN 1)	135000	0.4986	67311
5	CFAT (WN 1)	135000	0.419	56565
	Net Present Value			42763

Calculation of Net Present Value of Product B

Year	Cash Flow	Amount	DF @19%	Discounted Cash Flow @ 19%
0	Cost of Equipement	-530000	1	-530000
1	CFAT (WN 1)	188000	0.8403	157976
2	CFAT (WN 1)	188000	0.7062	132765.6
3	CFAT (WN 1)	188000	0.5934	111559.2
4	CFAT (WN 1)	188000	0.4986	93736.8
5	CFAT (WN 1)	188000	0.419	78772
	Net Present Value			44810

Conclusion:Product B is prefrred as the NPV of $ 44810 is higher than product A

Answer 2: Calculation of Payback Period

Step1: Compute total outflow of project

Step2: Compute CFAT for each year

Step3: Compute cumulative CFAT at the end of each year

Step4: Determine the year in which Cumulative CFAT exceeds Initial Investment

Step5: Payback period =Time at which cumulative CFAT =Initial Investment

Payback period of Product A

Year	Cash Flow	Amount	Cumulative CFAT
1	CFAT	135000	135000
2	CFAT	135000	270000
3	CFAT	135000	405000
4	CFAT	135000	540000
5	CFAT	135000	675000

Payback period=Time at which cumulative CFAT is equal to initial investment

Total Initial Investment (Outflow)=$370000

Payback period=2 years+(370000-270000)/(405000-270000)

=2 Years+100000/135000

Payback period=2 Years +0.74 years=2.74 years

Payback period of Product B

Year	Cash Flow	Amount	Cumulative CFAT
1	CFAT	188000	188000
2	CFAT	188000	376000
3	CFAT	188000	564000
4	CFAT	188000	752000
5	CFAT	188000	940000

Payback period=Time at which cumulative CFAT is equal to initial investment

Total Initial Investment (Outflow)=$530000

Payback period=2 years+(530000-376000)/(564000-376000)

=2 Years+154000/188000

Payback period =2 Years +0.82 years=2.82 years

Conclusion: Product A is preferred as payback period 2.74 years is less than Product B.

Answer 3: Calculation of Profitability Index=Present Value of Cash Inflow/Present Value of Cash Outflow

Calculation of Profitability Index of Product A

Year	Cash Flow	Amount	DF @19%	Discounted Cash Flow @ 19%
1	CFAT	135000	0.8403	113441
2	CFAT	135000	0.7062	95337
3	CFAT	135000	0.5934	80109
4	CFAT	135000	0.4986	67311
5	CFAT	135000	0.419	56565
6	Total PV of Cash Inflow			412763
7	Present Value of Cash Outflow			370000
8	Profitability Index (6/7)			1.12

Calculation of Profitability Index of Product B

Year	Cash Flow	Amount	DF @19%	Discounted Cash Flow @ 19%
1	CFAT	188000	0.8403	157976
2	CFAT	188000	0.7062	132766
3	CFAT	188000	0.5934	111559
4	CFAT	188000	0.4986	93737
5	CFAT	188000	0.419	78772
6	PV of Cash Inflow			574810
7	Present Value of Cash Outflow			530000
8	Profitability Index (6/7)			1.08

Conclusion: Product A is preferred as the PI 1.12 is higher than Product B

Answer 4:Computation of IRR

IRR is the rate of return at which the sum of discounted cash inflows equals the sum of discounted cash outflows.It is that rate of discount at which NPV =0

Calculation of IRR of Product A

Year	Cash Flow	Amount	DF @19%	Discounted Cash Flow @ 19%	DF @28%	Discounted Cash Flow @ 28
0	Cost of Equipement	-370000	1	-370000	1	-370000
1	CFAT	135000	0.8403	113441	0.7812	105462
2	CFAT	135000	0.7062	95337	0.6103	82390.5
3	CFAT	135000	0.5934	80109	0.4768	64368
4	CFAT	135000	0.4986	67311	0.3725	50287.5
5	CFAT	135000	0.419	56565	0.291	39285
	Net Present Value			42763		-28207

IRR=Lower Discount Rate+(NPV @ lower discount rate/NPV @ lower discount rate+NPV @ Higher discount rate)*(Higher discount rate-Lower discount  Rate)

IRR=19+42763/(42763+28207)*(28-19)

IRR of Product A =24.42%

Calculation of IRR of Product B

Year	Cash Flow	Amount	DF @19%	Discounted Cash Flow @ 19%	DF @28%	Discounted Cash Flow @ 28%
0	Cost of Equipement	-530000	1	-530000	1	-530000
1	CFAT	188000	0.8403	157976	0.7812	146865.6
2	CFAT	188000	0.7062	132765.6	0.6103	114736.4
3	CFAT	188000	0.5934	111559.2	0.4768	89638.4
4	CFAT	188000	0.4986	93736.8	0.3725	70030
5	CFAT	188000	0.419	78772	0.291	54708
	Net Present Value			44810		-54022

IRR=Lower Discount Rate+(NPV @ lower discount rate/NPV @ lower discount rate+NPV @ Higher discount rate)*(Higher discount rate-Lower discount  Rate)

IRR=19+44810/(44810+54022)*(28-19)

IRR of Product B =23.08%

Conclusion : Product A is preferred as IRR 24.42 is higher than Product B.

Answer 5: Calculation of Simple rate of Return=Profit After Tax/Initial Investment

Particulars	Product A	Product B
Sales	400000	510000
Less: Variable cost	180000	250000
Contribution	220000	260000
Less:Fixed Cost	85000	72000
Less: Depreciation	74000	106000
Profit Before Tax	61000	82000
Less: Tax	0	0
Profit After Tax(a)	61000	82000
Initial Investment(b)	370000	530000
Simple Rate of Return(a/b)*100	16.48%	15.47%