Question

Question 4 ch 8

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 24% 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)	$	320,000		$	515,000
Annual revenues and costs:
Sales revenues	$	370,000		$	470,000
Variable expenses	$	168,000		$	218,000
Depreciation expense	$	64,000		$	103,000
Fixed out-of-pocket operating costs	$	82,000		$	62,000

  

The company’s discount rate is 22%.

  

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%.)

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:

	Accept Product A
	Accept Product B
	Reject both products

Answer 1

Project A:

Initial Investment = $320,000

Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $370,000 - $168,000 - $64,000 - $82,000
Annual Net Income = $56,000

Annual Net Cash flows = Annual Net Income + Depreciation
Annual Net Cash flows = $56,000 + $64,000
Annual Net Cash flows = $120,000

Project B:

Initial Investment = $515,000

Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $470,000 - $218,000 - $103,000 - $62,000
Annual Net Income = $87,000

Annual Net Cash flows = Annual Net Income + Depreciation
Annual Net Cash flows = $87,000 + $103,000
Annual Net Cash flows = $190,000

Answer 1.

Project A:

Payback Period = Initial Investment / Annual Net Cash flows
Payback Period = $320,000 / $120,000
Payback Period = 2.67 years

Project B:

Payback Period = Initial Investment / Annual Net Cash flows
Payback Period = $515,000 / $190,000
Payback Period = 2.71 years

Answer 2.

Project A:

Net Present Value = -$320,000 + $120,000 * PVA of $1 (22%, 5)
Net Present Value = -$320,000 + $120,000 * 2.864
Net Present Value = $23,680

Project B:

Net Present Value = -$515,000 + $190,000 * PVA of $1 (22%, 5)
Net Present Value = -$515,000 + $190,000 * 2.864
Net Present Value = $29,160

Answer 3.

Project A:

Let IRR be i%

$320,000 = $120,000 * PVA of $1 (i%, 5)
PVA of $1 (i%, 5) = 2.667
Using table values, i = 25.4%

So, IRR is 25.4%

Project B:

Let IRR be i%

$515,000 = $190,000 * PVA of $1 (i%, 5)
PVA of $1 (i%, 5) = 2.711
Using table values, i = 24.6%

So, IRR is 24.6%

Answer 4.

Product A:

Profitability Index = Net Present Value / Initial Investment
Profitability Index = $23,680 / $320,000
Profitability Index = 0.07

Product B:

Profitability Index = Net Present Value / Initial Investment
Profitability Index = $29,160 / $515,000
Profitability Index = 0.06

Answer 5.

Project A:

Simple Rate of Return = Annual Net Income / Initial Investment
Simple Rate of Return = $56,000 / $320,000
Simple Rate of Return = 17.5%

Project B:

Simple Rate of Return = Annual Net Income / Initial Investment
Simple Rate of Return = $87,000 / $515,000
Simple Rate of Return = 16.9%

Answer 6-a.

Net Present Value = Project B
Profitability Index = Project A    
Payback Period = Project A
Internal Rate of Return = Project A
Simple Rate of Return = Project A

Answer 6-b.

Based on the simple rate of return, Lou Barlow would not accept any project as simple rate of return is lower than the return on investment.