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. 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) $ 310,000 $ 510,000 Annual revenues and costs: Sales revenues $ 360,000 $ 460,000 Variable expenses $ 164,000 $ 214,000 Depreciation expense $ 62,000 $ 102,000 Fixed out-of-pocket operating costs $ 81,000 $ 65,000 The company’s discount rate is 18%. Ignore income taxes. Note that Excel or a financial calculator must be used to calculate items 2 - 4. 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. 6a. For each measure, identify whether Product A or Product B is preferred.

Answer 1

	Product A	Product B
Initial investment	$ 310000	$ 510000
Net cash inflow:
sales	360000	460000
variable expense	(164000)	(214000)
Fixed operating expense	(81000)	(65000)
Net annual Cash inflow	115000	181000

1. payback period : = initial investment / net annual cash inflow

Product A = 310000 / 115000 = 2.69 years

Product B = 510000 / 181000 = 2.82 years

2.Net present value = Annual cash inflow *PVAF(18% , 5 years) - initial investment

Product A = 115000 * 3.12717 - 310000

= $ 49624.55

Product B = 181000 * 3.12717 - 510000

= $ 56017.77

3. Factor of Internal rate of return = initial investment / annual cash inflow

product A = 310000/ 115000 = 2.696

Product B = 510000/ 181000 = 2.818

Looking in Exhibit 13B-2 and scanning along the 5-period line, a factor of 2.696 is closet to 25% . so we assume IRR for product A is 25% .

2.818 is closet to 23 % . so for product B , IRR is 23%.

4. Project profitability index = net present value / initial investment

Product A = 49624.55 / 310000 = 0.16

Product B = 56017.77 / 510000 = 0.11

5. As per NPV factor , Product B is preferred.

But , as per payback period , profitability index , IRR , Product A is preferred.