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		$	56,000

  

The company’s discount rate is 18%.

  

Click here to view Exhibit 8B-1 and Exhibit 8B-2, to determine the appropriate discount factor using tables.

  

Required:

1. Calculate the payback period for each product. (Round your answers to 2 decimal places.)

2. Calculate the net present value for each product. (Round discount factor(s) to 3 decimal places.)

3. Calculate the internal rate of return for each product. (Round percentage answers to 1 decimal place. i.e. 0.1234 should be considered as 12.3% and round discount factor(s) to 3 decimal places.)

4. Calculate the project profitability index for each product. (Round discount factor(s) to 3 decimal places. Round your answers to 2 decimal places.)

5. Calculate the simple rate of return for each product. (Round percentage answers to 1 decimal place. i.e. 0.1234 should be considered as 12.3%.)

Answer 1

The payback period of Product A and Product B

Step 1- Calculation of Annual Net Cash Inflows

Annual Net Cash Inflows of Project A = Sales Revenue – Variable Expenses – Fixed out-of-pocket operating costs

                                                                  = 310,000 – 144,000 – 76,000 = 90,000

Annual Net Cash Inflows of Project B = Sales Revenue – Variable Expenses – Fixed out-of-pocket operating costs

                                                                   = 410,000 – 194,000 – 56,000 = 160,000

Step 2 – Computation of each products payback period

Payback Period of Product A = Investment Required / Annual Net Cash Flow

                                                   = 260,000/ 90,000 = 2.89 years

Payback Period of Product B = Investment Required / Annual Net Cash Flow

                                                   = 470,000/ 160,000 = 2.94 years