Question

8-23 Comprehensive Problem [LO8-1, LO8-2, LO8-3, LO8-5, LO8-6]

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 22% 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 $ 570,000 Annual revenues and costs: Sales revenues $ 400,000 $ 480,000 Variable expenses $ 182,000 $ 214,000 Depreciation expense $ 74,000 $ 114,000 Fixed out-of-pocket operating costs $ 88,000 $ 68,000 The company’s discount rate is 20%. Click here to view Exhibit 8B-1 and Exhibit 8B-2, to determine the appropriate discount factor 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. (Round discount factor(s) to 3 decimal places.)

3. Calculate the internal rate of return for each product. (Round percentage answers to 1 decimal place. i.e. 0.1234 should be considered as 12.3% and round discount factor(s) to 3 decimal places.)

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

5. Calculate the simple rate of return for each product. (Round percentage answers to 1 decimal place. i.e. 0.1234 should be considered as 12.3%.)

6a. For each measure, identify whether Product A or Product B is preferred. 6b. Based on the simple rate of return, Lou Barlow would likely: Accept Product A Accept Product B Reject both products

Answer 1

Answer to Question No.1
Year	Product A	Product B
0	370000	570000	Initial Investment
1 to 5	400000	480000	Sales Revenue
	-182000	-214000	Variable Expenses
	-88000	-68000	Fixed Out of Pocket Operating Expenses
Net Cash Flows ( year 1 to 5)	130000	198000
Terminal Cash Flows	NIL	NIL
Note:
Here in this question nothing is said about taxes , therefore Depreciation need not be deducted and then later added back to profit after taxes after tax adjustment.
Cash Pay Back Period - Non Discounted
Product A
	Year	Net CF	Un recovered Cash Flow
	0	-370000	-370000
	1	130000	-240000
Base Year	2	130000	-110000
	3	130000	20000
	4	130000	150000
	5	130000
Formula
Base Year +	(Un recovered Cash Flow of the base year/Cash Flow of the next Year) *12
Pay back period:
2 Years	10.00	Months	5 days
Product B
	Year	Net CF	Un recovered Cash Flow
	0	-570000	-570000
	1	198000	-372000
Base Year	2	198000	-174000
	3	198000	24000
	4	198000	222000
	5	198000
Pay back period:
2 Years	10.00	Months	16 days
Answer to Question 2 - NPV
			20.00%
Product A		PV Factor
Year	Net CF	D.F 20%	DCF
0	-370000	1	-370000
1 to 5	130000	2.991	388830
		Net Present Value(NPV)	18830
		388830	PV of Inflow
			20.00%
Product B		PV Factor
Year	Net CF	D.F 20%	DCF
0	-570000	1	-570000
1 to 5	198000	2.991	592218
0	0	0	0
		Net Present Value(NPV)	22218
		592218	PV of Inflow
Decision on NPV
Since the NPV of PRODUCT B is higher , Product B should be selected over PRODUCT A
Answer to Question 3
IRR
IRR is the rate at which NPV will becomes Zero.
Use a higher Rate so that NPV will get reduced and will be negative and near to Zero. , Say 25%				25.00%
PRODUCT A		PV Factor
Year	Net CF	D.F 7%	DCF
0	-370000	1	-370000
1 to 5	130000	2.689	349570
		Net Present Value(NPV)	-20430
Use a higher Rate so that NPV will get reduced and will be negative and near to Zero. , Say 25%
			25.00%
PRODUCT B		PV Factor
Year	Net CF	D.F 14%	DCF
0	-570000	1	-570000
1 to 5	198000	2.689	532422
		Net Present Value(NPV)	-37578
@ 25% NPV become Negative that means the IRR will be in between 20% and 25%
Let us find out IRR using interpolation formula
IRR=	L1+NPV (L1)/NPV(L1)-NPV(L2)*(l2-L1)
IRR = Product A	22.39811513	20+(2487200/(18830--20430))*(25-20)
IRR = Product B	21.85781658	20+(2487200/(22218--37578))*(25-20)
Decision on IRR
Product which has higher IRR should be selected , Therefore Product A which is having a higher IRR 22.40% than Product B which is having IRR 21.86% .
Answer to Question 5.Average Rate of Return(Simple rate of return)
Product A
Year	Net Cash flow	Depreciation(SLM)	Profit
0	-370000
1 to 5	130000	0	130000
		Average Profits	130000
	ARR=	Average PAT/Initial/Average Investment
		Based on Initial Investment
		35%
		35.13513514
		Based on Average Investment
		18%
		17.56756757
		Average Investment = Simple average of Beginning Value of Investment and Ending Value of the invetment
Product B
Year	Net CF	Depreciation(SLM)	Profit
0	-570000
1 to 5	198000	0	198000
0	0		0
		Average Profits	198000
	ARR=	Average PAT/Initial/Average Investment
		Based on Initial Investment
		35%
		34.73684211
		Based on Average Investment
		17%
		17.36842105
		Average Investment = Simple average of Beginning Value of Investment and Ending Value of the invetment
Decision based on ARR
Project A is better since ARR is higher than Project B
Answer to Question 4.Profitability Index
PLAN A
PI=	PV of Inflow/PV of Outflow
PI	1.050891892	(388830/370000)
PLAN B
PI=	PV of Inflow/PV of Outflow
PI	1.038978947	(592218/570000)
Decision
Product A is having higher Profitability index should be selected over Product B.