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 23% each of the last three years. He has computed the cost and revenue estimates for each product as follows: Product A Product B $ 300,000 $ 500,000 Initial investment: Cost of equipment (zero salvage value) Annual revenues and costs: Sales revenues Variable expenses Depreciation expense Fixed out-of-pocket operating costs $ 350,000 $ 160,000 $ 60,000 $ 80,000 $ 450,000 $ 210,000 $100,000 $ 61,000 The company's discount rate is 16%. 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: Complete this question by entering your answers in the tabs below.

Answer 1

Solutions:

Solution 1:
	Computation of Annual cash inflows
	Particulars	Product A	Product B
	Sales revenue	$3,50,000	$4,50,000
	Variable expenses	$1,60,000	$2,10,000
	Fixed Out of pocket operating cost	$80,000	$61,000
	Annual cash inflows	$1,10,000	$1,79,000
Payback period
Particulars	Choose Numerator	/	Choose Denominator	=	Payback Period
	Initial Investment	/	Annual Cash inflows	=	Payback Period
Product A	$3,00,000	/	$1,10,000	=	2.73	Years
Product B	$5,00,000	/	$1,79,000	=	2.79	Years
Solution 2:
Computation of NPV
			Product A		Product B
Particulars	Period	PV Factor (16%)	Amount	Present Value	Amount	Present Value
Cash outflows:
Initial investment	0	1	$3,00,000	$3,00,000	$5,00,000	$5,00,000
Present Value of Cash outflows (A)				$3,00,000		$5,00,000
Cash Inflows
Annual cash inflows	1-5	3.274	$1,10,000	$3,60,140	$1,79,000	$5,86,046
Present Value of Cash Inflows (B)				$3,60,140		$5,86,046
Net Present Value (NPV) (B-A)				$60,140		$86,046
Solution 3:
Computation of IRR
	Project A		Project B
Period	Cash flows	IRR	Cash flows	IRR
0	-$3,00,000	24.3%	-$5,00,000	23.2%
1	$1,10,000		$1,79,000
2	$1,10,000		$1,79,000
3	$1,10,000		$1,79,000
4	$1,10,000		$1,79,000
5	$1,10,000		$1,79,000
Solution 4:
Computation of Profitability Index
Particulars	Product A	Product B
Net present value	$60,140	$86,046
Initial investment	$3,00,000	$5,00,000
Profitability Index (PV of cash inflows / Initial investment)	0.20	0.17
Solution 5:
	Computation of Annual Operating income
	Particulars	Product A	Product B
	Annual cash inflows	$1,10,000	$1,79,000
	Less: depreciation	$60,000	$1,00,000
	Annual operating income	$50,000	$79,000
Simple rate of return
Particulars	Choose Numerator	/	Choose Denominator	=	Simple rate of return
	Annual operating income	/	Initial investment	=	Simple rate of return
Product A	$50,000	/	$3,00,000	=	16.7%
Product B	$79,000	/	$5,00,000	=	15.8%
Solution 6a:
Product Preference
Net present Value	Product B
Profitability index	Product A
Payback Period	Product A
IRR	Product A
Simple rate of Return	Product A
Solution 6b:
Based on Simple rate of return, Lou Barlow would likely reject both projects as their Simple rate of return is less than Division's ROI (23%).