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		$	58,000

The company’s discount rate is 18%.

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

Req a1:
Payback period			Product A	Product B
Initial investment			260000	470000
Divide: Annual cashinflows			90000	158000
Payback period			2.89	2.97
Req 2:
NPV
			Product A	Product B
Annual Inflows			90000	158000
Annuity PV factor at 8%			3.9927	3.9927
Present value of inflows			359343	630846.6
Less: Initial investment			260000	470000
NPV			99343	160846.6
Req 3:
IRR
			Product A	Product B
Annual Inflows			90000	158000
Annuity PV factor		(at 21.60%)	2.8889	2.9742	(at 20.25%)
Present value of inflows			260001	469923.6
Less: Initial investment			260000	470000
NPV			1	-76.4
IRR			21.60%	20.25%
Req 4:
Profitability Index:
			Product A	Product B
Annual Inflows			90000	158000
Annuity PV factor at 8%			3.9927	3.9927
Present value of inflows			359343	630846.6
Divide:Initial Investment			260000	470000
Profitability Index			1.38	1.34
Req 5:
			Product A	Product B
Net income			38000	64000
Divide: Average Investment			130000	235000
Average rate of return			29.23%	27.23%
Req 6:
		Preference
Payback		Product A
NPV		Product B
IRR		Product A
PI		Product A
SIMPLE Rate of Return		Product A
Req 6-b:
Lou Barlow would likely to accept both the products.