In: Accounting

# Problem 12-23 Comprehensive Problem [LO12-1, LO12-2, LO12-3, LO12-5, LO12-6] Lou Barlow, a divisional manager for Sage...

Problem 12-23 Comprehensive Problem [LO12-1, LO12-2, LO12-3, LO12-5, LO12-6]

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 22% 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) $370,000$ 570,000 Annual revenues and costs: Sales revenues $400,000$ 480,000 Variable expenses $180,000$ 214,000 Depreciation expense $74,000$ 114,000 Fixed out-of-pocket operating costs $88,000$ 68,000

The company’s discount rate is 20%.

Click here to view Exhibit 12B-1 and Exhibit 12B-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:

## Solutions

##### Expert Solution

Solution 1:

 Computation of Annual cash inflows Particulars Product A Product B Sales revenue $400,000.00$480,000.00 Variable expenses $180,000.00$214,000.00 Fixed Out of pocket operating cost $88,000.00$68,000.00 Annual cash inflows $132,000.00$198,000.00
 Payback period Particulars Choose Numerator / Choose Denominator = Payback Period Initial Investment / Annual Cash inflows = Payback Period Product A $370,000.00 /$132,000.00 = 2.80 Years Product B $570,000.00 /$198,000.00 = 2.88 Years

Solution 2:

 Computation of NPV Product A Product B Particulars Period PV Factor Amount Present Value Amount Present Value Cash outflows: Initial investment 0 1 $370,000$370,000 $570,000$570,000 Present Value of Cash outflows (A) $370,000$570,000 Cash Inflows Annual cash inflows 1-5 2.991 $132,000$394,812 $198,000$592,218 Present Value of Cash Inflows (B) $394,812$592,218 Net Present Value (NPV) (B-A) $24,812$22,218

Solution 3:

 Computation of IRR Period Product A Product B Cash Flows IRR Cash Flows IRR 0 -$370,000.00 23.0% -$570,000.00 21.8% 1 $132,000.00$198,000.00 2 $132,000.00$198,000.00 3 $132,000.00$198,000.00 4 $132,000.00$198,000.00 5 $132,000.00$198,000.00

Solution 4:

 Computation of Profitability Index Particulars Product A Product B NPV $24,812$22,218 Initial investment $370,000$570,000 Profitability Index (PV of cash inflows / Initial investment) 0.07 0.04

solution 5:

 Computation of Annual Operating income Particulars Product A Product B Annual cash inflows $132,000.00$198,000.00 Less: depreciation $74,000.00$114,000.00 Annual operating income $58,000.00$84,000.00
 Simple rate of return Particulars Choose Numerator / Choose Denominator = Simple rate of return Annual operating income / Initial investment = Simple rate of return Product A $58,000.00 /$370,000.00 = 15.7% Product B $84,000.00 /$570,000.00 = 14.7%

Solution 6a:

 Product Preference Payback Period Product A Net Present Value Product A IRR Product A Profitability index Product A Simple rate of return Product A

Solution 6b:

Based on simple rate of return, lou barlow would likely to reject both the products as it will decrease overall ROI of the division.

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