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 20% 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)	$	260,000		$	470,000
Annual revenues and costs:
Sales revenues	$	310,000		$	410,000
Variable expenses	$	144,000		$	194,000
Depreciation expense	$	52,000		$	94,000
Fixed out-of-pocket operating costs	$	76,000		$	56,000

  

The company’s discount rate is 18%.

  

Click here to view Exhibit 8B-1 and Exhibit 8B-2, to determine the appropriate discount factor using tables.

  

Required:

1. Calculate the payback period for each product. (Round your answers to 2 decimal places.)

2. Calculate the net present value for each product. (Round discount factor(s) to 3 decimal places.)

3. Calculate the internal rate of return for each product. (Round percentage answers to 1 decimal place. i.e. 0.1234 should be considered as 12.3% and round discount factor(s) to 3 decimal places.)

4. Calculate the project profitability index for each product. (Round discount factor(s) to 3 decimal places. Round your answers to 2 decimal places.)

5. Calculate the simple rate of return for each product. (Round percentage answers to 1 decimal place. i.e. 0.1234 should be considered as 12.3%.)

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:

	Accept Product A
	Accept Product B
	Reject both products

Answer 1

Project A:

Initial Investment = $260,000

Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $310,000 - $144,000 - $52,000 - $76,000
Annual Net Income = $38,000

Annual Net Cash flows = Annual Net Income + Depreciation
Annual Net Cash flows = $38,000 + $52,000
Annual Net Cash flows = $90,000

Project B:

Initial Investment = $470,000

Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $410,000 - $194,000 - $94,000 - $56,000
Annual Net Income = $66,000

Annual Net Cash flows = Annual Net Income + Depreciation
Annual Net Cash flows = $66,000 + $94,000
Annual Net Cash flows = $160,000

Answer 1.

Project A:

Payback Period = Initial Investment / Annual Net Cash flows
Payback Period = $260,000 / $90,000
Payback Period = 2.89 years

Project B:

Payback Period = Initial Investment / Annual Net Cash flows
Payback Period = $470,000 / $160,000
Payback Period = 2.94 years

Answer 2.

Project A:

Net Present Value = -$260,000 + $90,000 * PVA of $1 (18%, 5)
Net Present Value = -$260,000 + $90,000 * 3.127
Net Present Value = $21,430

Project B:

Net Present Value = -$470,000 + $160,000 * PVA of $1 (18%, 5)
Net Present Value = -$470,000 + $160,000 * 3.127
Net Present Value = $30,320

Answer 3.

Project A:

Let IRR be i%

$260,000 = $90,000 * PVA of $1 (i%, 5)
PVA of $1 (i%, 5) = 2.889
Using table values, i = 21.6%

So, IRR is 21.6%

Project B:

Let IRR be i%

$470,000 = $160,000 * PVA of $1 (i%, 5)
PVA of $1 (i%, 5) = 2.938
Using table values, i = 20.8%

So, IRR is 20.8%

Answer 4.

Product A:

Profitability Index = Net Present Value / Initial Investment
Profitability Index = $21,430 / $260,000
Profitability Index = 0.08

Product B:

Profitability Index = Net Present Value / Initial Investment
Profitability Index = $30,320 / $470,000
Profitability Index = 0.06

Answer 5.

Project A:

Simple Rate of Return = Annual Net Income / Initial Investment
Simple Rate of Return = $38,000 / $260,000
Simple Rate of Return = 14.6%

Project B:

Simple Rate of Return = Annual Net Income / Initial Investment
Simple Rate of Return = $66,000 / $470,000
Simple Rate of Return = 14.0%

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.