Question

Problem 13-23 Comprehensive Problem [LO13-1, LO13-2, LO13-3, LO13-5, LO13-6]

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 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)	$	220,000		$	410,000
Annual revenues and costs:
Sales revenues	$	280,000		$	380,000
Variable expenses	$	130,000		$	182,000
Depreciation expense	$	44,000		$	82,000
Fixed out-of-pocket operating costs	$	73,000		$	60,000

The company’s discount rate is 14%.

Click here to view Exhibit 13B-1 and Exhibit 13B-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.

6b. Based on the simple rate of return, Lou Barlow would likely:

Answer 1

13-23)
1) Payback period _
Product A = initial investment / annual cash flow
220000 / (280000-130000-73000) = 2.86 years
Product B = 410000 / (380000-182000-60000) = 2.97 years
2) NPV = Annual cash flow * PVIFA(discount rate, n) - Initial investment
Product A = 77000 * PVIFA(14% , 5) - 220000 = 77000 * 3.433 - 220000 = 44341
Product B = 138000 * PVIFA(14% , 5) - 410000 = 138000 * 3.433 - 410000 = 63754
3) IRR =
discount rate		14%	15%
present value
Product A		77000*3.433= 264341	77000*3.352=258104
Product B		138000*3.433= 473754	138000*3.352=462576
IRR (Product A) = 14% + (264341 - 220000) / (264341 - 258104) % = 14% + 7.11% = 21.11%
IRR (Product B) = 14% + (473754 - 410000) / (473754 - 462576) % = 19.70%
4) Project Profitability index = present value of future cash flow / initial investment
Product A = 264341 / 220000 = 1.20
Product B = 473754 / 410000 = 1.16
5) Simple rate of return = Net Income / Initial investment
Product A = 33000 / 220000 = 15%
Product B = 56000 / 410000 = 13.66%
6) Product A is preferred in all terms.