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 25% 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)	$	340,000		$	525,000
Annual revenues and costs:
Sales revenues	$	380,000		$	480,000
Variable expenses	$	172,000		$	225,000
Depreciation expense	$	68,000		$	105,000
Fixed out-of-pocket operating costs	$	83,000		$	66,000

The company’s discount rate is 17%.

Click here to view Exhibit 12B-1 and Exhibit 12B-2, to determine the appropriate discount factor using tables.

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.

5. Calculate the simple rate of return for each product.

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:

Answer 1

Project A:

Initial Investment = $340,000

Annual Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $380,000 - $172,000 - $68,000 - $83,000
Annual Net Income = $57,000

Annual Net Cash flows = Annual Net Income + Annual Depreciation
Annual Net Cash flows = $57,000 + $68,000
Annual Net Cash flows = $125,000

Project B:

Initial Investment = $525,000

Annual Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $480,000 - $225,000 - $105,000 - $66,000
Annual Net Income = $84,000

Annual Net Cash flows = Annual Net Income + Annual Depreciation
Annual Net Cash flows = $84,000 + $105,000
Annual Net Cash flows = $189,000

Answer 1.

Project A:

Payback Period = Initial Investment / Annual Net Cash flows
Payback Period = $340,000 / $125,000
Payback Period = 2.72 years

Project B:

Payback Period = Initial Investment / Annual Net Cash flows
Payback Period = $525,000 / $189,000
Payback Period = 2.78 years

Answer 2.

Project A:

Net Present Value = -$340,000 + $125,000 * PVA of $1 (17%, 5)
Net Present Value = -$340,000 + $125,000 * 3.199
Net Present Value = $59,875

Project B:

Net Present Value = -$525,000 + $189,000 * PVA of $1 (17%, 5)
Net Present Value = -$525,000 + $189,000 * 3.199
Net Present Value = $79,611

Answer 3.

Project A:

Let IRR be i%

$340,000 = $125,000 * PVA of $1 (i%, 5)
PVA of $1 (i%, 5) = 2.720
Using table values, i = 24.4%

So, IRR is 24.4%

Project B:

Let IRR be i%

$525,000 = $189,000 * PVA of $1 (i%, 5)
PVA of $1 (i%, 5) = 2.778
Using table values, i = 23.4%

So, IRR is 23.4%

Answer 4.

Product A:

Profitability Index = Net Present Value / Initial Investment
Profitability Index = $59,875 / $340,000
Profitability Index = 0.18

Product B:

Profitability Index = Net Present Value / Initial Investment
Profitability Index = $79,611 / $525,000
Profitability Index = 0.15

Answer 5.

Project A:

Simple Rate of Return = Annual Net Income / Initial Investment
Simple Rate of Return = $57,000 / $340,000
Simple Rate of Return = 16.8%

Project B:

Simple Rate of Return = Annual Net Income / Initial Investment
Simple Rate of Return = $84,000 / $525,000
Simple Rate of Return = 16.0%

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.