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 21% 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)	$	270,000		$	480,000
Annual revenues and costs:
Sales revenues	$	320,000		$	420,000
Variable expenses	$	148,000		$	198,000
Depreciation expense	$	54,000		$	96,000
Fixed out-of-pocket operating costs	$	77,000		$	57,000

The company’s discount rate is 19%.

Click here to view Exhibit 13B-1 and Exhibit 13B-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.

Answer 1

Solution 1:

Computation of Annual cash inflows
Particulars	Product A	Product B
Sales revenue	$320,000.00	$420,000.00
Variable expenses	$148,000.00	$198,000.00
Fixed Out of pocket operating cost	$77,000.00	$57,000.00
Annual cash inflows	$95,000.00	$165,000.00

Payback period
Particulars	Choose Numerator	/	Choose Denominator	=	Payback Period
	Initial Investment	/	Annual Cash inflows	=	Payback Period
Product A	$270,000.00	/	$95,000.00	=	2.84	Years
Product B	$480,000.00	/	$165,000.00	=	2.91	Years

Solution 2:

Computation of NPV
			Product A		Product B
Particulars	Period	PV Factor (19%)	Amount	Present Value	Amount	Present Value
Cash outflows:
Initial investment	0	1	$270,000	$270,000	$480,000	$480,000
Present Value of Cash outflows (A)				$270,000		$480,000
Cash Inflows
Annual cash inflows	1-5	3.058	$95,000	$290,510	$165,000	$504,570
Present Value of Cash Inflows (B)				$290,510		$504,570
Net Present Value (NPV) (B-A)				$20,510		$24,570

Solution 3:

Computation of IRR
Period	Product A		Product B
	Cash Flows	IRR	Cash Flows	IRR
0	-$270,000.00	22.4%	-$480,000.00	21.3%
1	$95,000.00		$165,000.00
2	$95,000.00		$165,000.00
3	$95,000.00		$165,000.00
4	$95,000.00		$165,000.00
5	$95,000.00		$165,000.00