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)	$	340,000		$	540,000
Annual revenues and costs:
Sales revenues	$	390,000		$	490,000
Variable expenses	$	176,000		$	226,000
Depreciation expense	$	68,000		$	108,000
Fixed out-of-pocket operating costs	$	84,000		$	64,000

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

Annual revenue			390000	490000
Less: Vraiable cost			176000	226000
Less: Fixed cost			84000	64000
Annual cash inflows			130000	200000
less: Annual dep			68000	108000
Annual net income			62000	92000
Average investment			170000	270000
req 1.
Pay back periiod: Investmennt/ Annual cash inflows
A: 340000 /62000 = 5.48 years
B: 540000/92000 = 5.87 years
Req 2:
Net present value at 18%			product A	Product B
Annual inflows			130000	200000
Annuity for 5 yeas at 18%			3.1272	3.1272
Present value of inflows			406536	625440
Less: Investment			340000	540000
NPV			66536	85440
Req 3:
IRR
Net present value at 18%			product A	Product B
Annual inflows			130000	200000
Annuity for 5 yeas at 26.5%			2.6086	2.703	(at 24.75%)
Present value of inflows			339118	540600
Less: Investment			340000	540000
NPV			-882	600
Hence, IRR			26.50%	24.75%
Req 4:
Profitability Index:
			A	B
Present value of inflows			406536	625440
Divide: Investment			340000	540000
Profitability Indx			1.2	1.16
Req 5:			A	B
Annual Income			62000	92000
Divide: Average Investment			170000	270000
Rate of return			36.47%	34.07%
Rreq 6:
		Choose
Payback		A
NPV		B
IRR		A
Profitability		A
Rreq 6-b:
Product A shall be selected undere rate of return method.