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)	$	370,000		$	530,000
Annual revenues and costs:
Sales revenues	$	400,000		$	510,000
Variable expenses	$	180,000		$	250,000
Depreciation expense	$	74,000		$	106,000
Fixed out-of-pocket operating costs	$	85,000		$	72,000

The company’s discount rate is 19%.

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.

6a. For each measure, identify whether Product A or Product B is preferred.

Answer 1

Project A:

Initial Investment = $370,000

Annual Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $400,000 - $180,000 - $74,000 - $85,000
Annual Net Income = $61,000

Annual Net Cash flows = Annual Net Income + Depreciation
Annual Net Cash flows = $61,000 + $74,000
Annual Net Cash flows = $135,000

Project B:

Initial Investment = $530,000

Annual Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $510,000 - $250,000 - $106,000 - $72,000
Annual Net Income = $82,000

Annual Net Cash flows = Annual Net Income + Depreciation
Annual Net Cash flows = $82,000 + $106,000
Annual Net Cash flows = $188,000

Answer 1.

Project A:

Payback Period = Initial Investment / Annual Net Cash flows
Payback Period = $370,000 / $135,000
Payback Period = 2.74 years

Project B:

Payback Period = Initial Investment / Annual Net Cash flows
Payback Period = $530,000 / $188,000
Payback Period = 2.82 years

Answer 2.

Project A:

Net Present Value = -$370,000 + $135,000 * PVA of $1 (19%, 5)
Net Present Value = -$370,000 + $135,000 * 3.058
Net Present Value = $42,830

Project B:

Net Present Value = -$530,000 + $188,000 * PVA of $1 (19%, 5)
Net Present Value = -$530,000 + $188,000 * 3.058
Net Present Value = $44,904

Answer 3.

Project A:

Let IRR be i%

$370,000 = $135,000 * PVA of $1 (i%, 5)
PVA of $1 (i%, 5) = 2.741
Using table values, i = 24.1%

So, IRR is 24.1%

Project B:

Let IRR be i%

$530,000 = $188,000 * PVA of $1 (i%, 5)
PVA of $1 (i%, 5) = 2.819
Using table values, i = 22.7%

So, IRR is 22.7%

Answer 4.

Product A:

Profitability Index = Net Present Value / Initial Investment
Profitability Index = $42,830 / $370,000
Profitability Index = 0.12

Product B:

Profitability Index = Net Present Value / Initial Investment
Profitability Index = $44,904 / $530,000
Profitability Index = 0.08

Answer 6-a.

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