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)	$	250,000		$	460,000
Annual revenues and costs:
Sales revenues	$	300,000		$	400,000
Variable expenses	$	135,000		$	190,000
Depreciation expense	$	50,000		$	92,000
Fixed out-of-pocket operating costs	$	75,000		$	55,000

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:

Req 1

Req 2

Req 3

Req 4

Req 5

Req 6A

Req 6B

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 Calculate the simple 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 Simple rate of return % % For each measure, identify whether Product A or Product B is preferred. Net Present Value Profitability Index Payback Period Internal Rate of Return Simple Rate of Return Based on the simple rate of return, Lou Barlow would likely: Accept Product A Accept Product B Reject both products

Answer 1

Calculation of Net Cash inflow
& Operating Profit
	Product A	Product B
Sales Revenues	300,000	400,000
Less: Variable Expenses	(135,000)	(190,000)
Less: Fixed out of Pocket Exp.	(75,000)	(55,000)
Net Cash inflow	90,000	155,000
Less: Dep.	(50,000)	(92,000)
Net Operating Income	40,000	63,000
Answer 1.
Payback period = Intial investment / Cash Inflow per period
Calculation of Pay Back Period
	Product A	Product B
Intial Investment (A)	250,000	460,000
Cash Inflow per Annum (B)	90,000	155,000
Pay Back Period (A/B)	2.78 Years	2.97 Years
Answer 2.
Calculation of NPV of Project
Particulars	Year	18% Factor	Project A		Project B
			Amount	Present value	Amount	Present value
		C	D	C X D	E	C X E
Cash Inflow
Net Cash Inflow	1 -5	3.12717	90,000	281,445	155,000	484,711
A. Total Cash Inflow - PV				281,445		484,711
Cash Outflow
Cost of Investment	0	1.00000	250,000	250,000	460,000	460,000.0000
B. Total Cash Outflow - PV				250,000		460,000
NPV (A - B)				31,445		24,711
Answer 3.
	Year	Project A	Project B
Intial Investment	0	(250,000)	(460,000)
Expcted Net Cash inflow	1	90,000	155,000
	2	90,000	155,000
	3	90,000	155,000
	4	90,000	155,000
	5	90,000	155,000
Internal Rate of Return		23.44%	20.35%
Answer 4.
Project Profitability Index = PV of cash Inflow / Intial Investment
	Project A	Project B
PV of Cash Inflow (A)	281,445	484,711
Intial investment (B)	250,000	460,000
Project Profitability Index (A/B)	1.13	1.05
Answer 5.
Simple Rate of Return = Average Accounting Profit / Intial Investment
	Project A	Project B
Net operating profit (A)	40,000	63,000
Intial Investment (B)	250,000	460,000
Simple Rate of Return (A/B)	16.00%	13.70%
Answer 6a.
Net Present Value	Profitability Index	Payback Period	Internal Rate of Return
Project B	Project A	Project A	Project A
Answer 6b. Reject Both Project
Since, Simple rate of return is Less then the Expected rate of return (20%)