In: Accounting
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:
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.