Question

Problem 13-23 Comprehensive Problem [LO13-1, LO13-2, LO13-3, LO13-5, LO13-6]

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 24% 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)	$	330,000		$	515,000
Annual revenues and costs:
Sales revenues	$	370,000		$	470,000
Variable expenses	$	168,000		$	218,000
Depreciation expense	$	66,000		$	103,000
Fixed out-of-pocket operating costs	$	82,000		$	68,000

The company’s discount rate is 15%.

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.

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

	Product A Product B Payback period years years

Calculate the net present value for each product. (Round your final answers to the nearest whole dollar amount.)

	Product A Product B Net present value

Calculate the internal rate of return for each product. (Round your answers to 1 decimal place i.e. 0.123 should be considered as 12.3%.)

	Product A Product B Internal rate of return % %

Calculate the project profitability index for each product. (Round your answers to 2 decimal places.)

	Product A Product B Project profitability index

Answer 1

Answer
Calculation of Payback period
		Product A	Product B
Payback Period		2.75 years	3 years
Calculation of Net Present Value of the products
Year	Discount Factor @ 15%	Product A		Product B
		Cashflow	Present value of Cashflow	Cashflow	Present value of Cashflow
0	1	(330,000)	(330,000)	(515,000)	(515,000)
1	0.8695	120,000	104,340	184,000	159,988
2	0.7561	120,000	90,732	184,000	139,122
3	0.6575	120,000	78,900	184,000	120,980
4	0.5717	120,000	68,604	184,000	105,193
5	0.4971	120,000	59,652	184,000	91,466
Net Present Value			72,228		101,750
Calculation of Internal Rate of Return of the products (IRR)
		Product A	Product B
IRR		23.62%	22.52%
Calculation of Profitability Index
		Product A	Product B
NPV (calculated above)		72,228	101,750
Initial Investment		330,000	515,000
Profitability Index		0.22	0.20
Workings
Calculation of Cashflows
			Product A	Product B
			$	$
Sales Revenue			370,000	470,000
Less Variable Cost			(168,000)	(218,000)
Less: Fixed Cost ( excluding depreciation)			(82,000)	(68,000)
Net Cashflow			120,000	184,000
Payback Period	=	Initial Investment/ Annual Cashdlows
			Product A	Product B
Initial Investment			330,000	515,000
Annual Cash flow			120,000	184,000
Payback period			2.75	2.80
Calculation of NPV @ Highest Rate
Year	Discount Factor @ 25%	Product A		Product B
		Cashflow	Present value of Cashflow	Cashflow	Present value of Cashflow
0	1	(330,000)	(330,000)	(515,000)	(515,000)
1	0.8	120,000	96,000	184,000	147,200
2	0.64	120,000	76,800	184,000	117,760
3	0.512	120,000	61,440	184,000	94,208
4	0.4096	120,000	49,152	184,000	75,366
5	0.3276	120,000	39,312	184,000	60,278
Net Present Value			(7,296)		(20,187)
Calculation of Internal Rate of Return of the products (IRR)
	IRR =	L + ({NPV(L) / (NPV(L) - NPV(H))} X (H -L))
	Where,
	L =	Lower discount rate
	H =	Higher discount rate
	NPV(L)	NPV calculated @ lowest rate
	NPV(H)	NPV calculated @ Highest rate
For Product A,
	IRR =	10 + (72228/ 72228 - (-7296)) X (25 - 10)
	=	23.62%
For Product B,
	IRR =	10 + (101750/ 101750 - (-20187)) X (25 - 10)
	=	22.52%