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 19% 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)	$	190,000		$	400,000
Annual revenues and costs:
Sales revenues	$	270,000		$	370,000
Variable expenses	$	128,000		$	178,000
Depreciation expense	$	38,000		$	80,000
Fixed out-of-pocket operating costs	$	72,000		$	52,000

The company’s discount rate is 17%.

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

Computation of Annual cash Inflow:

	Product A	Product B
Sales revenue	270,000	370,000
Less:
Variable expenses	(128,000)	(178,000)
Fixed out of pocket operating cost	(72,000)	(52,000)
Annual cash inflows	70,000	140,000

Note: As tax are not given here, so depreciation will not be used for calculation of annual cash flows.

1 1. Payback Period 2 Initial Investment 3 Annual Cash inflows 4 Payback Period Product A 190000 70000 2.71 Product B 400000 140000 2.86 6 2. Calcualtion of NPV: 8 Initial Investment 9 Annual Cash inflows 10 Net Present value (NPV) Year 0 1-5 Product A -190000 70000 Product B PV@17% PV of Product APV of Product B -400000 1 - 190000 -400000 1400003.199 223930 447860 33930 47860 12 3. Calcualtion of IRR 13 Year 14 Product A -190000 70000 70000 70000 70000 70000 24.55% Product B -400000 140000 140000 140000 140000 140000 22.11% 18 20 Internal Rate of Return (IRR) 22 4. Calculation of PI 24 Present value of cash inflows 25 Initial Investment 26 Product A 223930 190000 1.18 Product B 447860 400000 1.12

28 5. Annual Operating Income 29 Annual Cash inflows 30 Less: Depreciation expenses 70000 38000 32000 140000 80000 60000 31 32000 33 6. Simple rate of return 34 Annual Operating Income 35 Initial Investment 36 % 190000 16.84 60000 400000 15.00

Calculated as:

1 1. Payback Period 2 Initial Investment 3 Annual Cash inflows 4 Payback Period Product A 190000 =270000-128000-72000 =C2/C3 Product B 400000 |=370000-178000-52000 =D2/D3 6 2. Calcualtion of NPV: Year PV@17% PV of Product A PV of Product B O Product A - 190000 =270000-128000-72000 8 Initial Investment 9 Annual Cash inflows 10 Net Present value (NPV) Product B -400000 =370000-178000-52000 =C8*E8 3.199 -C9*E9 =D8*E8 =D9*E9 =G8+G9 =F8+F9 12 3. Calcualtion of IRR Product A - 190000 70000 70000 70000 70000 70000 =IRR(C14:C19) Product B -400000 140000 140000 140000 140000 140000 =IRR(D14:D19) 20 Internal Rate of Return (IRR) 22 4. Calculatior Product A 24 Present value of cash inflows =F9 25 Initial Investment 190000 =B24/B25 Product B =G9 400000 =C24/C25 26

28 5. Annual Operating Income 29 Annual Cash inflows 30 Less: Depreciation expenses 70000 38000 =B29-B30 140000 80000 =C29-C30 32 33 6. Simple rate of return 34 Annual Operating Income 35 Initial Investment 36 % 32000 190000 =B34/B35*100 60000 400000 =C34/C35*100

6a.

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 its less than 19%.