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 23% 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)	$	300,000		$	500,000
Annual revenues and costs:
Sales revenues	$	350,000		$	450,000
Variable expenses	$	160,000		$	210,000
Depreciation expense	$	60,000		$	100,000
Fixed out-of-pocket operating costs	$	80,000		$	61,000

The company’s discount rate is 16%.

Click here to view Exhibit 13B-1 and Exhibit 13B-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

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Lou Barlow	Figures in US $		Note
Particulars	Product A	Product B
Cost of equipment	300,000.00	500,000.00		A
Sales Revenue	350,000.00	450,000.00		B
Variable expenses	160,000.00	210,000.00		C
Operating Expense	80,000.00	61,000.00		D
Operating cash outflow	240,000.00	271,000.00		E=C+D
Net Operating cash inflow	110,000.00	179,000.00		F=B-E
Payback Period (Years)	2.73	2.79	Answer 1	G=A/F
Project A is preferred as payback period is less.			Answer 6a
Annuity factor of 16% for 5 years	3.274	3.274		H
Present Value of Net Operating cash inflow	360,172.30	586,098.56		I=H*F
Net Present Value of cash inflow	60,172.30	86,098.56	Answer 2	J=I-A
Project B is preferred as NPV is more.			Answer 6a
Calculation of Internal Rate of Return			Answer 3
Annuity factor of 24.4% for 5 years	2.727			K
Present Value of Net Operating cash inflow	300,000.00			L=K*F
Present Value of cash inflow	-			M=L-A
Internal Rate of Return is 24.4%
Annuity factor of 23.2% for 5 years		2.793		N
Present Value of Net Operating cash inflow		500,000.00		O=N*F
Present Value of cash inflow		-		P=O-A
Internal Rate of Return is 23.2%
Project A is preferred as rate of return is more.			Answer 6a
Project Profitability Index	1.20	1.17	Answer 4	Q=I/A
Project A is preferred as its Profitability Index is more.			Answer 6a
Simple Rate of Return	36.67%	35.80%	Answer 5	R=F/A
Project A is preferred as rate of return is more.			Answer 6a

Answer 6b

Based on simple rate of return Lou Barlow will invest in Project A as its return is more.

Please Note- Depreciation is not considered as it is a non cash expense.