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)	$	360,000		$	530,000
Annual revenues and costs:
Sales revenues	$	400,000		$	510,000
Variable expenses	$	180,000		$	250,000
Depreciation expense	$	72,000		$	106,000
Fixed out-of-pocket operating costs	$	85,000		$	65,000

  

The company’s discount rate is 19%.

  

2.

	Product A Product B Net present value

	Product A Product B Project profitability index

	Product A Product B Simple rate of return % %

	Net Present Value Profitability Index Payback Period

Answer 1

Computation of annual cash inflows and annual net income
			Product A	Product B
Sales revenue			400000	510,000
Less: Variable expense			180000	250,000
Less: Fixed cost out of pocket exp			85000	65,000
Annual Cash inflows			135000	195,000
Less: depreciation			72000	106,000
Annual Net income			63000	89,000
Average investment			180000	265000
(Investment /2)
NPV:
			Product A	Product B
Annual Cash inflows			135000	195000
Annuity Factor at 19% for 5 years			3.0576	3.0576
Present value of inflows			412776	596232
Less: Initial Investment			360000	530000
Net present value			52776	66232
Project Profitability index:
			Product A	Product B
Present value of Inflows			412776	596232
Divide: Initial Investment			360000	530000
Profitability Index			1.15	1.125
Rate of return:
			Product A	Product B
Annual net income			63000	89000
Divide: Average investment			180000	265000
Average rate of return			35%	33.58%
Choice of projeect
		NPV	PI	Rate of return
Selection		Product B	Product A	Product A