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		$	540,000
Annual revenues and costs:
Sales revenues	$	390,000		$	490,000
Variable expenses	$	176,000		$	226,000
Depreciation expense	$	68,000		$	108,000
Fixed out-of-pocket operating costs	$	84,000		$	64,000

The company’s discount rate is 18%.

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

Solution 1:

Computation of Annual cash inflows
Particulars	Product A	Product B
Sales revenue	$3,90,000.00	$4,90,000.00
Variable expenses	$1,76,000.00	$2,26,000.00
Fixed Out of pocket operating cost	$84,000.00	$64,000.00
Annual cash inflows	$1,30,000.00	$2,00,000.00

Payback period
Particulars	Choose Numerator	/	Choose Denominator	=	Payback Period
	Initial Investment	/	Annual Cash inflows	=	Payback Period
Product A	$3,40,000.00	/	$1,30,000.00	=	2.62	Years
Product B	$5,40,000.00	/	$2,00,000.00	=	2.70	Years

Solution 2:

Computation of NPV
			Product A		Product B
Particulars	Period	PV Factor (18%)	Amount	Present Value	Amount	Present Value
Cash outflows:
Initial investment	0	1	$3,40,000	$3,40,000	$5,40,000	$5,40,000
Present Value of Cash outflows (A)				$3,40,000		$5,40,000
Cash Inflows
Annual cash inflows	1-5	3.127	$1,30,000	$4,06,510	$2,00,000	$6,25,400
Present Value of Cash Inflows (B)				$4,06,510		$6,25,400
Net Present Value (NPV) (B-A)				$66,510		$85,400

Solution 3:

Computation of IRR
	Project A		Project B
Period	Cash flows	IRR	Cash flows	IRR
0	-$3,40,000.00	26.4%	-$5,40,000.00	24.8%
1	$1,30,000.00		$2,00,000.00
2	$1,30,000.00		$2,00,000.00
3	$1,30,000.00		$2,00,000.00
4	$1,30,000.00		$2,00,000.00
5	$1,30,000.00		$2,00,000.00

Solution 4:

Computation of Profitability Index
Particulars	Product A	Product B
Net present value	$66,510	$85,400
Initial investment	$3,40,000	$5,40,000
Profitability Index (PV of cash inflows / Initial investment)	0.20	0.16

Solution 5:

Computation of Annual Operating income
Particulars	Product A	Product B
Annual cash inflows	$1,30,000.00	$2,00,000.00
Less: depreciation	$68,000.00	$1,08,000.00
Annual operating income	$62,000.00	$92,000.00

Simple rate of return
Particulars	Choose Numerator	/	Choose Denominator	=	Simple rate of return
	Annual operating income	/	Initial investment	=	Simple rate of return
Product A	$62,000.00	/	$3,40,000.00	=	18.2%
Product B	$92,000.00	/	$5,40,000.00	=	17.0%

Solution 6a:

Product Preference
Payback Period	Product A
Net Present Value	Product B
Profitability index	Product A
IRR	Product A
Simple rate of Return	Product A

Solution 6b:

Based on Simple rate of return, Lou Barlow would likely reject both projects as their Simple rate of return is less than Division's ROI (25%).