Question

Problem 13-23 Comprehensive Problem [LO13-1, LO13-2, LO13-3, LO13-5, LO13-6]

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 23% 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)	$	390,000		$	585,000
Annual revenues and costs:
Sales revenues	$	420,000		$	500,000
Variable expenses	$	185,000		$	222,000
Depreciation expense	$	78,000		$	117,000
Fixed out-of-pocket operating costs	$	90,000		$	70,000

The company’s discount rate is 21%.

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

Answer:
Row 1/Column A		1. Calculate the payback period for each product.
2
3		Payback period means the time within which we can recover our cost of initial investment
4
5		It would be calculated as follows:
6			Product A		Product B
7	A	Sales revenue	4,20,000		5,00,000
8	B	Less: Variable expenses	1,85,000		2,22,000
9	C	Less: Out-of-pocket fixed expenses	90,000		70,000
10	D=A-B-C	Annual cash inflow	1,45,000	(420,000-185,000-90,000)	2,08,000	(500,000-222,000-70,000)
11	E	Cost of equipment	3,90,000		5,85,000
12	F=D/E	Payback period
13		(Cost of equipment/Net annual cash inflow)	2.69	(145,000/390,000)	2.81	(208,000/585,000)
14
15
16		2. Calculate the net present value for each product.
17		Product A
18
19		Particulars	Year
20			0	1	2	3	4	5
21	a	Annual cash inflow		1,45,000	1,45,000	1,45,000	1,45,000	1,45,000
22	b	Less: Cost of equipment	$         3,90,000.00
23	c=a-b	Net annual cash inflow	$       (3,90,000.00)	$ 1,45,000.00	$ 1,45,000.00	$ 1,45,000.00	$ 1,45,000.00	$       1,45,000.00
24	d	Discount at 21%	1	0.8264	0.6830	0.5645	0.4665	0.3855
25	e=c*d	Present Value	$       (3,90,000.00)	$ 1,19,834.71	$     99,036.95	$     81,848.72	$     67,643.57	$          55,903.78
26	f= Sum of all Present Value	Net present value	34,267.73
27
28		Product B
29
30		Particulars	Year
31			0	1	2	3	4	5
32	a	Annual cash inflow		2,08,000	2,08,000	2,08,000	2,08,000	2,08,000
33	b	Less: Cost of equipment	$         5,85,000.00
34	c=a-b	Net annual cash inflow	$       (5,85,000.00)	$ 2,08,000.00	$ 2,08,000.00	$ 2,08,000.00	$ 2,08,000.00	$       2,08,000.00
35	d	Discount at 18%	1	0.8264	0.6830	0.5645	0.4665	0.3855
36	e=c*d	Present Value	$       (5,85,000.00)	$ 1,71,900.83	$ 1,42,066.80	$ 1,17,410.58	$     97,033.54	$          80,193.00
37	f= Sum of all Present Value	Net present value	23,604.74
38
39
40		3. Calculate the internal rate of return for each product.
41			Product A		Product B
42		IRR	24.99%	=IRR(D23:I23)	22.85%	=IRR(D34:I34)
43
44		4. Calculate the project profitability index for each product.
45
46		Profitability Index	=1 + NPV/Initial investment
47			Product A		Product B
			=1 +(34,267.73/390,000)		=1 +(23,604.74/585,000)
			1.09		1.04