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. 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) $ 190,000 $ 400,000 Annual revenues and costs: Sales revenues $ 270,000 $ 370,000 Variable expenses $ 128,000 $ 178,000 Depreciation expense $ 38,000 $ 80,000 Fixed out-of-pocket operating costs $ 72,000 $ 52,000 The company’s discount rate is 17%. Ignore income taxes. Note that Excel or a financial calculator must be used to calculate items 2 - 4. 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. 6a. For each measure, identify whether Product A or Product B is preferred.

Answer 1

		Product A	Product B
	Cost of Equipment	1,90,000	4,00,000
A	Yearly Revenue	2,70,000	3,70,000
B	Yearly Variable Expenses	1,28,000	1,78,000
C	Yearly Fixed Out of Pocket Expenses	72,000	52,000
D	Earnings Before Interest Taxes and Depreciation(A-B-C)	70,000	1,40,000

Depreciation is not a cash expenses. Hence it is not to be included in comparison of the viability of 2 projects.

Question (a)

The payback period for each each product can be computed as Initial Investment/ EBITDA which will give you the number of years for payback

Product A = 190000/70000 = 2.71 years = 2 years,8 Months and 15 days

Product B = 400000/140000 = 2.85 years = 2 years, 10 months and 8 days.

If Payback period is used as a criteria, Product A is prefereable because it pays back earlier.

Question (b)

The Net present Value of the products are the sum of the cash flows discounted at the discounted rate.

Product A NPV = (70000)/(1+17%) + (70000)/(1+17%)² + (70000)/(1+17%)³ + (70000)/(1+17%)⁴ + (70000)/(1+17%)⁵ - 190,000 = 362,408.44

Product B NPV = (140000)/(1+17%) + (140000)/(1+17%)² + (140000)/(1+17%)³ + (140000)/(1+17%)⁴ + (140000)/(1+17%)⁵ - 400,000 = 704,816.87

Product B gives the higher NPV which implies higher returns. Hence it is preferable

Question (c)

The IRR of a product is the discount rate at which NPV is 0;

The general method of computing IRR is trial and error method substituting different discount rates to arrive at the one where NPV becomes 0. However, using Excel we can simply calculate IRR of a project using the IRR formula:

the First Step is to List the cash flows

Product A

Year 0	-1,90,000
Year 1	70,000
Year 2	70,000
Year 3	70,000
Year 4	70,000
Year 5	70,000

Now we can simply apply the IRR formula as follows:

Using this formula we can compute the IRR for Product A to be 24.55%

Product B IRR is 22.11%

Based on the IRR rule, the higher IRR of Product A is preferred since it is much higher than the cost of capital.

Question (d)

Profitability index(PI) is the PV of Future Cash Flows/Initial Investment

PI for Product A = (70000)/(1+17%) + (70000)/(1+17%)² + (70000)/(1+17%)³ + (70000)/(1+17%)⁴ + (70000)/(1+17%)⁵ /190,000 = 1.18

PI for Product B = (140000)/(1+17%) + (140000)/(1+17%)² + (140000)/(1+17%)³ + (140000)/(1+17%)⁴ + (140000)/(1+17%)⁵ /400,000 = 1.12

Based on the profitability index, Product A is preferable.