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. 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	$	380,000		$	460,000
Variable expenses	$	170,000		$	206,000
Depreciation expense	$	68,000		$	108,000
Fixed out-of-pocket operating costs	$	86,000		$	66,000

The company’s discount rate is 20%.

Ignore income taxes. Note that Excel or a financial calculator must be used to calculate items 2 - 4.

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.

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

Answer 1

Solution 1:

Annual cash inflows:

Product A = $380,000 - $170,000 - $86,000 = $124,000

Prodcut B = $460,000 - $206,000 - $66,000 = $188,000

Payback period = Initial investment / Annual cash inflows

Product A = $340,000 / $124,000 = 2.74 years

Product B = $540,000 / $188,000 = 2.87 years

Product A is preferred

Solution 2:

Computation of NPV
			Product A		Product B
Particulars	Period	PV Factor (20%)	Amount	Present Value	Amount	Present Value
Cash outflows:
Initial investment	0	1	$340,000	$340,000	$540,000	$540,000
Present Value of Cash outflows (A)				$340,000		$540,000
Cash Inflows
Annual cash inflows	1-5	2.99061	$124,000	$370,836	$188,000	$562,235
Present Value of Cash Inflows (B)				$370,836		$562,235
Net Present Value (NPV) (B-A)				$30,836		$22,235

Product A is preferred

Solution 3:

Computation of IRR
Period	Product A		Product B
	Cash Flow	IRR	Cash Flow	IRR
0	-$340,000.00	24.06%	-$540,000.00	21.86%
1	$124,000.00		$188,000.00
2	$124,000.00		$188,000.00
3	$124,000.00		$188,000.00
4	$124,000.00		$188,000.00
5	$124,000.00		$188,000.00

Product A is preferred.

Solution 4:

Project profitability index = Present value of cash inflows / Initial investment

Product A = $370,836/$340,000 = 1.09

Product B = $562,235 / $540,000 = 1.04