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)	$	340,000		$	540,000
Annual revenues and costs:
Sales revenues	$	390,000		$	490,000
Variable expenses	$	176,000		$	226,000
Depreciation expense	$	68,000		$	108,000
Fixed out-of-pocket operating costs	$	84,000		$	64,000

  

The company’s discount rate is 18%.

  

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.

Answer 1

Project A:

Initial Investment = $340,000

Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $390,000 - $176,000 - $68,000 - $84,000
Annual Net Income = $62,000

Annual Net Cash flows = Annual Net Income + Depreciation
Annual Net Cash flows = $62,000 + $68,000
Annual Net Cash flows = $130,000

Project B:

Initial Investment = $540,000

Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $490,000 - $226,000 - $108,000 - $64,000
Annual Net Income = $92,000

Annual Net Cash flows = Annual Net Income + Depreciation
Annual Net Cash flows = $92,000 + $108,000
Annual Net Cash flows = $200,000

Answer 1.

Project A:

Payback Period = Initial Investment / Annual Net Cash flows
Payback Period = $340,000 / $130,000
Payback Period = 2.62 years

Project B:

Payback Period = Initial Investment / Annual Net Cash flows
Payback Period = $540,000 / $200,000
Payback Period = 2.70 years

Answer 2.

Project A:

Net Present Value = -$340,000 + $130,000 * PVA of $1 (18%, 5)
Net Present Value = -$340,000 + $130,000 * 3.1272
Net Present Value = $66,536

Project B:

Net Present Value = -$540,000 + $200,000 * PVA of $1 (18%, 5)
Net Present Value = -$540,000 + $200,000 * 3.1272
Net Present Value = $85,440

Answer 3.

Project A:

Let IRR be i%

$340,000 = $130,000 * PVA of $1 (i%, 5)
PVA of $1 (i%, 5) = 2.6154
Using table values, i = 26.37%

So, IRR is 26.4%

Project B:

Let IRR be i%

$540,000 = $200,000 * PVA of $1 (i%, 5)
PVA of $1 (i%, 5) = 2.70
Using table values, i =24.8%

So, IRR is 24.8%

Answer 4.

Product A:

Profitability Index = Net Present Value / Initial Investment
Profitability Index = $66,536 / $340,000
Profitability Index = 0.20

Product B:

Profitability Index = Net Present Value / Initial Investment
Profitability Index = $85,440 / $540,000
Profitability Index = 0.16

Answer 5.

Project A:

Simple Rate of Return = Annual Net Income / Initial Investment
Simple Rate of Return = $62,000 / $340,000
Simple Rate of Return = 18.24%

Project B:

Simple Rate of Return = Annual Net Income / Initial Investment
Simple Rate of Return = $92,000 / $540,000
Simple Rate of Return = 17.04%

Answer 6-a.

Net Present Value = Project B
Profitability Index = Project A
Payback Period = Project A
Internal Rate of Return = Project A