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) $ 370,000 $ 530,000 Annual revenues and costs: Sales revenues $ 400,000 $ 510,000 Variable expenses $ 180,000 $ 250,000 Depreciation expense $ 74,000 $ 106,000 Fixed out-of-pocket operating costs $ 85,000 $ 72,000 The company’s discount rate is 19%. Click here to view Exhibit 7B-1 and Exhibit 7B-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. Based on the simple rate of return, Lou Barlow would likely.

Answer 1

a	Compute payback period of both products as shown below:
	Particulars	Product A ($)	Product B ($)
	Investment (A)	370000	530000
	Annual net cash flows (B)	135000	188000
	Payback period (A/B)	2.74	2.82
	Compute annual net cash inflows
	Particulars	Product A ($)	Product B ($)
	Sales Revenue (A)	400000	510000
	Variable expense (B)	180000	250000
	Fixed-out-of-pocket operating cost ©	85000	72000
	Annual net cash flows (A-B-C)	135000	188000
b	Compute the NPV for product A as shown below:
	Particulars	Year 0 ($)	Year 1 ($)	Year 2($)	Year 3 ($)	Year 4 ($)	Year 5($)	Total ($)
	Cost of equipment (A)	-370000						-370000
	Sales revenue (B)		400000	400000	400000	400000	400000
	Variable expense ©		180000	180000	180000	180000	180000
	Fixed-out-of-pocket operating cost (D)		85000	85000	85000	85000	85000
	Annual net cash flows (B-C-D)=E		135000	135000	135000	135000	135000
	Present value discount factor F		0.8403	0.7062	0.5934	0.4987	0.4190
	Present value (E*F)=G		113445	95332	80111	67320	56572	412781
	Net present value (A-G)							42781
	Compute the NPV for product B as shown below:
	Particulars	Year 0 ($)	Year 1 ($)	Year 2($)	Year 3 ($)	Year 4 ($)	Year 5($)	Total ($)
	Cost of equipment (A)	-530000						-530000
	Sales revenue (B)		510000	510000	510000	510000	510000
	Variable expense ©		250000	250000	250000	250000	250000
	Fixed-out-of-pocket operating cost (D)		72000	72000	72000	72000	72000
	Annual net cash flows (B-C-D)=E		188000	188000	188000	188000	188000
	Present value discount factor F		0.8403	0.7062	0.5934	0.4987	0.4190
	Present value (E*F)=G		157983	132759	111562	93750	78781	574835
	Net present value (A-G)							44835
3	Compute IRR for product A and product B
	year	cost of investment ($)	Sales revenue ($)	Variable expense ($)	Fixed-out-of-pocket operating cost($)	Annual cash flows ($)
	0	-370000				-370000
	1		400000	180000	85000	135000
	2		400000	180000	85000	135000
	3		400000	180000	85000	135000
	4		400000	180000	85000	135000
	5		400000	180000	85000	135000
		Internal rate of return (IRR) product A				26.50%
	year	cost of investment ($)	Sales revenue ($)	Variable expense ($)	Fixed-out-of-pocket operating cost($)	Annual cash flows ($)
	0	-530000				-530000
	1		510000	250000	72000	188000
	2		510000	250000	72000	188000
	3		510000	250000	72000	188000
	4		510000	250000	72000	188000
	5		510000	250000	72000	188000
		Internal rate of return (IRR) product B				23%
4	Compute profitability index for product A and Product B
	Particulars	Product A ($)	Product B ($)
	Net present value (A)	42781	44835
	Cost of investment (B)	370000	530000
	Profitability Index (A/B)	0.116	0.085
5	compute simple rate of return for product A and product B
	Particulars	Product A ($)	Product B ($)
	Sales revenue (A)	400000	510000
	Variable expense (B)	180000	250000
	Fixed-out-of-pocket operating cost ©	85000	72000
	Depreciation expense (D)	74000	106000
	Annual net cash flows (A-B-C-D)= E	61000	82000
	Cost of investment (F)	370000	530000
	Simple rate of return (E/F)	16.49%	15.47%
6(a)	Measure	Product Preferred
	payback period	product A
	Net present value	Product B
	Internal rate of return	product A
	Profitability index	product A
	Simple rate of return	product A
6(b)	Simple rate of return for product A 16.49% and product B 15.47%. The ROI is 19%. Both rate of return is less than ROI. So Lou
	Barlow reject both the products