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 22% 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) $ 380,000 $ 575,000
  Annual revenues and costs:
  Sales revenues $ 410,000 $ 490,000
  Variable expenses $ 186,000 $ 218,000
  Depreciation expense $ 76,000 $ 115,000
  Fixed out-of-pocket operating costs $ 89,000 $ 69,000

  

The company’s discount rate is 20%.

  

Click here to view Exhibit 11B-1 and Exhibit 11B-2, to determine the appropriate discount factor(s) 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. (Use the appropriate table to determine the discount factor(s).)

     

3.

Calculate the project profitability index for each product. (Use the appropriate table to determine the discount factor(s). Round your answers to 2 decimal places.)

     

4.

Calculate the simple rate of return for each product. (Round percentage answer to 1 decimal place. i.e. 0.1234 should be considered as 12.3% and use the appropriate table to determine the discount factor(s).)

     

5a.

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

     

5b.

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

Accept Product A
Accept Product B
Reject both products

Answer 1

	Product A	Product B
Sales Revenue	$410,000.00	$490,000.00
Less: Variable Expenses	$186,000.00	$218,000.00
Less: Fixed Expenses	$89,000.00	$69,000.00
Annual Free Cash Flow	$135,000.00	$203,000.00

Answer 1. Payback period of Product A = 380000/135000 = 2.81 years

Payback period of Product B = 575000/203000 = 2.83 years

Answer 2.

NPV pf Product A = -380000 + 135000 * PVIFA (20%,5) = -380000 + 135000 * 2.990612 = $23732.62

NPV of Product B = -575000 + 203000 * PVIFA (20%,5) = -575000 + 203000 * 2.990612 = $32094.24

Answer 3.

Profitability Index of Product A = (23732.62 + 380000)/380000 = 1.062 i.e. 1.06

Profitability Index of Product B = (32094.24 + 575000)/575000 = 1.056 i.e. 1.06

Answer 4.

Simple Rate of Return of Product A = (135000 – 76000) / 380000 = 59000/380000 = 15.53%

Simple Rate of Return of Product B = (203000 – 115000) / 575000 = 88000/575000 = 15.30%

Answer 5a. Payback Period: Product A

NPV: Product B

Profitability Index: Product A (Rounding off to two decimal points make both products appear same)

Simple Rate of Return: Product A

If Lou Barlow is likely to compare the Simple Rate of Return to his annual Increment, then he is likely to reject both projects.