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 17% 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)	$	180,000		$	390,000
Annual revenues and costs:
Sales revenues	$	260,000		$	360,000
Variable expenses	$	124,000		$	174,000
Depreciation expense	$	36,000		$	78,000
Fixed out-of-pocket operating costs	$	71,000		$	50,000

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

Calculation of Pay back Period, NPV, IRR, Profitability Index, simple rate of return for Product A & B
Period	Initial Cost (A)	Cash Inflows{B}	Net Cash Inflows (A-B)	P.V.A.F @ 17%	P.V @ 17%	P.V.A.F @ 25%	P.V @ 25%
0	-1,80,000	0	-1,80,000	1.00000	-1,80,000	1.00000	-1,80,000
1-5		65000	65,000	3.19935	2,07,958	2.68928	1,74,803
				NPV	27,958		-5,197
Period	Initial Cost (A)	Cash Inflows{B}	Net Cash Inflows (A-B)	P.V.A.F @ 17%	P.V @ 17%	P.V.A.F @ 25%	P.V @ 25%
0	-3,90,000	0	-3,90,000	1.00000	-3,90,000	1.00000	-3,90,000
1-5		136000	1,36,000	3.19935	4,35,112	2.68928	3,65,742
				NPV	45,112		-24,258
a) Calculation of Pay back period:	Product A	Product B
=Initial Investment/Cash inflows	2.77	2.87
	(180000/65000)	(390000/136000)
	Preferred
b) Calculation of NPV:	Product A	Product B
NPV	27,958	45,112
		Preferred
c) Calculation of IRR:
IRR= Lower Discount Rate + [ Lower Rate NPV / ( Lower Rate NPV - Higher Rate NPV )]*(Higher Discount Rate-Lower Discount Rate)
So By putting figure into this formula IRR is
	Product A	Product B
IRR	23.59%	21.93%
	Preferred
d) Profitability Index=
(NPV+ initial Investment)
initial investment
	Product A	Product B
NPV	27,958	45,112
Initial Investment	1,80,000	3,90,000
Total	2,07,958	4,35,112
PI	1.16	1.12
	Preferred
e) Simple Rate of return:
Annual Income
initial investment
	Product A	Product B
Annual Income	29,000	58,000
Initial Investment	1,80,000	3,90,000
Simple Rate of Return	16.11%	14.87%
	Preferred
Working Note:
Sales	260000	360000
Less: Variable Expenses	-124000	-174000
Fixed Operating Cost	-71000	-50000
Cash flows	65000	136000
Less: Dep.	-36000	-78000
Annual Income	29000	58000