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)	$	340,000		$	540,000
Annual revenues and costs:
Sales revenues	$	380,000		$	460,000
Variable expenses	$	170,000		$	206,000
Depreciation expense	$	68,000		$	108,000
Fixed out-of-pocket operating costs	$	86,000		$	66,000

The company’s discount rate is 20%.

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

			Product A	Product B
1	Payback period	=	2.74	2.87
2	Net Present Value	=	$             30,884	$ 22,308
3	IRR	=	24.1%	21.9%
4	Profitability Index	=	1.09	1.04
5	Simple rate of return	=	16.5%	14.8%
6a	Net Present Value	Profitability Index	Payback period	IRR
	Product A	Product A	Product A	Product A
6b	Simple rate of return	=	Product A
	Workings:
	Product A:
2
		Year	Value Flows	Present Factor @20%	Present Value
	Initial Cost	0	$       -3,40,000	1	$              -3,40,000
	Cash Inflows ($380000-$170000-$86000)	1 - 5	$         1,24,000	2.991	$                3,70,884
	Net Present Value				$                   30,884
	Product B:
		Year	Value Flows	Present Factor @20%	Present Value
	Initial Cost	0	$       -5,40,000	1	$              -5,40,000
	Cash Inflows ($460000-$206000-$66000)	1 - 5	$         1,88,000	2.991	$                5,62,308
	Net Present Value				$                   22,308
1	Product A:
	Payback period	=	Initial investment / Annual net cash flows
		=	2.74	years
	Product B:
	Payback period	=	Initial investment / Annual net cash flows
		=	2.87	years
3	Computation of IRR
	Product A:
		Year	Value Flows
		0	$       -3,40,000
		1	$         1,24,000
		2	$         1,24,000
		3	$         1,24,000
		4	$         1,24,000
		5	$         1,24,000
	IRR	=	24.06%
		Formula	=IRR(I15:I20)
	Product B:
		Year	Value Flows
		0	$       -5,40,000
		1	$         1,88,000
		2	$         1,88,000
		3	$         1,88,000
		4	$         1,88,000
		5	$         1,88,000
	IRR	=	21.86%
		Formula	=IRR(I15:I20)
4	Product A:
	Profitability Index	=	1 + NPV/Initial Investment
			1 + $30884/ $340000
		=	1.09
	Product B:
	Profitability Index	=	1 + NPV/Initial Investment
			1 + $22308 / $540000
		=	1.04
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