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 24% 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)	$	330,000		$	515,000
Annual revenues and costs:
Sales revenues	$	370,000		$	470,000
Variable expenses	$	168,000		$	218,000
Depreciation expense	$	66,000		$	103,000
Fixed out-of-pocket operating costs	$	82,000		$	68,000

The company’s discount rate is 15%.

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.

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

Answer 1

solution 1:

Computation of Annual cash inflows
Particulars	Product A	Product B
Sales revenue	$370,000.00	$470,000.00
Variable expenses	$168,000.00	$218,000.00
Fixed Out of pocket operating cost	$82,000.00	$68,000.00
Annual cash inflows	$120,000.00	$184,000.00

Payback period
Particulars	Choose Numerator	/	Choose Denominator	=	Payback Period
	Initial Investment	/	Annual Cash inflows	=	Payback Period
Product A	$330,000.00	/	$120,000.00	=	2.75	Years
Product B	$515,000.00	/	$184,000.00	=	2.80	Years

Solution 2:

Computation of NPV
			Product A		Product B
Particulars	Period	PV Factor	Amount	Present Value	Amount	Present Value
Cash outflows:
Initial investment	0	1	$330,000	$330,000	$515,000	$515,000
Present Value of Cash outflows (A)				$330,000		$515,000
Cash Inflows
Annual cash inflows	1-5	3.352	$120,000	$402,240	$184,000	$616,768
Present Value of Cash Inflows (B)				$402,240		$616,768
Net Present Value (NPV) (B-A)				$72,240		$101,768

Solution 3:

Computation of IRR
Period	Product A		Product B
	Cash Flows	IRR	Cash Flows	IRR
0	-$330,000.00	23.9%	-$515,000.00	23.1%
1	$120,000.00		$184,000.00
2	$120,000.00		$184,000.00
3	$120,000.00		$184,000.00
4	$120,000.00		$184,000.00
5	$120,000.00		$184,000.00

Solution 4:

Computation of Profitability Index
Particulars	Product A	Product B
NPV	$72,240	$101,768
Initial investment	$330,000	$515,000
Profitability Index (PV of cash inflows / Initial investment)	0.22	0.20

Solution 5:

Computation of Annual Operating income
Particulars	Product A	Product B
Annual cash inflows	$120,000.00	$184,000.00
Less: depreciation	$66,000.00	$103,000.00
Annual operating income	$54,000.00	$81,000.00

Simple rate of return
Particulars	Choose Numerator	/	Choose Denominator	=	Simple rate of return
	Annual operating income	/	Initial investment	=	Simple rate of return
Product A	$54,000.00	/	$330,000.00	=	16.4%
Product B	$81,000.00	/	$570,000.00	=	14.2%

Solution 6a:

Product Preference
Payback Period	Product A
Net Present Value	Product B
IRR	Product A
Profitability index	Product A
Simple rate of return	Product A

Solution 6b:

Based on simple rate of return, lou barlow would likely to reject both the products as it will decrease overall ROI of the division.