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

discount rate is 18%

1. calculate the internal rate of return for each product (A & B) in % ... round answer to 1 decimal place

Answer 1

Solution 1:

Computation of Annual cash Inflows
Particulars	Product A	Product B
Annual Sales Revenues	$390,000.00	$490,000.00
Less: Annual Cash Cost:
Variable Expenses	$176,000.00	$226,000.00
Fixed operating cost	$84,000.00	$64,000.00
Annual Cash Inflows	$130,000.00	$200,000.00

At IRR Present value of cash flows will be equal to cost of equipment.

Product A:

Lets calculate present value of cash inflows at 26% and 27%

PV of cash inflows at 26% = $130,000 * cumulative PV Factor for 5 periods at 26%

= $130,000 * 2.63507 = $342,559

PV of cash inflows at 27% = $130,000 * cumulative PV Factor for 5 periods at 27%

= $130,000 * 2.58267 = $335,747

IRR = 26% + ($342,559 - $340,000) / ($342,559 - $335,747)

= 26.38%

Product B:

Lets calculate present value of cash inflows at 24% and 25%

PV of cash inflows at 24% = $200,000 * cumulative PV Factor for 5 periods at 24%

= $200,000 * 2.74538 = $549,077

PV of cash inflows at 25% = $200,000 * cumulative PV Factor for 5 periods at 25%

= $200,000 * 2.68928 = $537,856

IRR = 24% + ($549,077 - $540,000) / ($549,077 - $537,856)

= 24.81%