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 20% 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)	$	260,000		$	470,000
Annual revenues and costs:
Sales revenues	$	310,000		$	410,000
Variable expenses	$	144,000		$	194,000
Depreciation expense	$	52,000		$	94,000
Fixed out-of-pocket operating costs	$	76,000		$	56,000

  

The company’s discount rate is 18%.

  

Click here to view Exhibit 11B-1 and Exhibit 11B-2, to determine the appropriate discount factor(s) using tables.

    

Required:

1.	Calculate the payback period for each product. (Round your answers to 2 decimal places.)

     

2.	Calculate the net present value for each product. (Use the appropriate table to determine the discount factor(s).)

     

3.	Calculate the project profitability index for each product. (Use the appropriate table to determine the discount factor(s). Round your answers to 2 decimal places.)

     

4.	Calculate the simple rate of return for each product. (Round percentage answer to 1 decimal place. i.e. 0.1234 should be considered as 12.3% and use the appropriate table to determine the discount factor(s).)

     

5a.	For each measure, identify whether Product A or Product B is preferred.

     

5b.	Based on the simple rate of return, Lou Barlow would likely:
	Accept Product A Accept Product B Reject both products

Answer 1

1) Payback period = investment required / annual net cash inflows

	Product A	Product B
Annual net cash flows
Sales revenue	$3,10,000	$4,10,000
Less: variable expenses	$1,44,000	$1,94,000
Fixed out of pocket operating expenses	$76,000	$56,000
Annual net cash flows	$90,000	$1,60,000
Investment required	$2,60,000	$4,70,000
Payback period	2.89 years	2.94 years

2)  

	Product A	Product B
Investment required	$2,60,000	$4,70,000
Sales revenue	$3,10,000	$4,10,000
Less: variable expenses	$1,44,000	$1,94,000
Fixed out of pocket operating expenses	$76,000	$56,000
Annual net cash flows	$90,000	$1,60,000
Cumulative PV of $1 per annum for n year	3.127	3.127
(18% , 5)
Present value of cash inflows	$2,81,430	$5,00,320
NPV	$21,430	$30,320

3) Profitability index = PV of cash inflows / initial investment

	Product A	Product B
Present value of cash inflows	$2,81,430	$5,00,320
Investment required	$2,60,000	$4,70,000
PI	1.08	1.06

4) Rate of return = average accounitng profit / investment rewuired

	Product A	Product B
Investment required	$2,60,000	$4,70,000
Sales revenue	$3,10,000	$4,10,000
Less: variable expenses	$1,44,000	$1,94,000
Fixed out of pocket operating expenses	$76,000	$56,000
Depreciation	$52,000	$94,000
Annual acccounting profit	$38,000	$66,000
ROR	14.62%	14.04%

5a)

Payback period	Product A
NPV	Product B
PI	Product A
ROR	Product A

5b) Based on the simle rate of return, Lou Barlow will reject both the projects as the return is less than 20% which is the divisions return on investment for the last three years and his annual pay raises are determined by this.