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

Cash Flow

Product A = $310000 – 144000 - $76000 = $90000

Product B =$410000 – 194000 – 56000 = $160000

Net Income

Product A = $38000    

Product B =$66000

1.Calculate the payback period for each product

= Initial Investment / cash flow

Product A = $260000 / 90000 = 2.99 Years

Product B = $470000 / 160000 = 2.94 Years

2.Calculate the net present value for each product.

Product A = ($90000 x 3.12717) - $260000

                   = 281445 – 260000

                   = $ 21,445

Product B = ($160000 x 3.12717) - $470000 = $ 30,347

                   = 500347 – 470000

                   = $30,347

3.Calculate the project profitability index for each product

Profitability Index = Present value of cash flow / Investment

Product A = $2,81,445 / 260000 = 1.08

Product B = 500347 / 470000 = 1.06

4.Calculate the simple rate of return for each product.

simple rate of return = (Net Income / Investment)*100

Product A = ($38000 / 260000) * 100 14.62%

Product B = (66000 / 470000 ) *100 = 14.04%

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

Payback Method = Product B

NPV Method = Product B

Profitability Index Method = Product A

Simple Rate of return = Product A