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)	$	220,000		$	410,000
Annual revenues and costs:
Sales revenues	$	280,000		$	380,000
Variable expenses	$	130,000		$	182,000
Depreciation expense	$	44,000		$	82,000
Fixed out-of-pocket operating costs	$	73,000		$	60,000

The company’s discount rate is 14%.

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

1. Payback Period: Investment / Net Annual Cash Flow

Product A = $220000 / ($280000 - 130000 - 73000)

Product A = $220000 / $77000 = 2.86 Years

Product B = $410000 / ($380000 - 182000 - 600000)

Product B = $220000 / $77000 = 2.97 Years

Based on Payback Period Product A is preferable investment

2. Computation of NPV

3. Computation of IRR

4. Product Profitability Ratio

Product A = 1 + NPV / Initial Investment = 1 + 44347.23 / 220000 = 1.20

Product B = 1 + NPV / Initial Investment = 1 + 63765.17 / 410000 = 1.16

Based on PI Product A is Preferable

5. Simple Rate of Return = Net Income / Investment

Product A = 33000 / 220000 = 15%

Product B = 56000 / 410000 = 13.66%

6b. Based on the simple rate of return, Lou Barlow would likely accept Product A