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)	$	280,000		$	480,000
Annual revenues and costs:
Sales revenues	$	330,000		$	430,000
Variable expenses	$	152,000		$	202,000
Depreciation expense	$	56,000		$	96,000
Fixed out-of-pocket operating costs	$	78,000		$	60,000

The company’s discount rate is 14%.

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

1) Calculation of payback period for each product (Amount in $)

Particulars	Product A	Product B
a) Sales Revenue	330,000	430,000
b) Variable Expenses	152,000	202,000
c) Fixed out of pocket operating costs	78,000	60,000
d) Net annual cash inflow (a-b-c)	100,000	168,000
e) Initial Investment	280,000	480,000
f) Pay Back Period (e/d)	2.80	2.86

According to payback period measure, Product A is preferred as its PBP is less.

2) Product A

Present Value of Annual cash inflows = Annual cash inflows*PVAF(14%,5 yrs)

= $100,000*3.43308 = $343,308

Initial Investment (Cash outflow) = $280,000

Net Present Value (NPV) of Product A = PV of cash inflows - Cash Outflows

= $343,308 - $280,000 = $63,308

Product B

Present Value of Annual cash inflows = Annual cash inflows*PVAF(14%,5 yrs)

= $168,000*3.43308 = $576,757

Initial Investment (Cash outflow) = $480,000

Net Present Value (NPV) of Product B = PV of cash inflows - Cash Outflows

= $576,757 - $480,000 = $96,757

According to NPV measure, Product B is preferred as its NPV is more.

3) Product A

Initial Investment = $280,000

Annual Net cash inflows = $100,000

Required Present value Annuity Factor = Initial Investment/Annual net cash inflows

= $280,000/$100,000 = 2.80

Now for calculating Internal Rate of return, we need to find this PVAF of 2.80 in the PVAF table and scanning along the five period line. In the PVAF table, 2.80 falls under 23% (almost) for five period line.

Therefore the Internal Rate of Return for Product A is 23% (or 23.059% by financial calculator)

Product B

Initial Investment = $480,000

Annual Net cash inflows = $168,000

Required Present value Annuity Factor = Initial Investment/Annual net cash inflows

= $480,000/$168,000 = 2.8571

Now for calculating Internal Rate of return, we need to find this PVAF of 2.8571 in the PVAF table and scanning along the five period line. In the PVAF table, 2.8571 falls between 22% and 23%

Therefore the Internal Rate of Return for Product A is 22.106% (by financial calculator).

According to IRR measure, Product A is preferred as IRR is more for Product A.

4) Project Profitability Index = Net Present Value/Initial Investment

Project Profitability Index of Product A = $63,308/$280,000 = 0.23

Project Profitability Index of Product B = $96,757/$480,000 = 0.20

According to Project Profitability Index, Product A is preferred as its Project Profitability Index is more.