Question

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 22% 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) $ 370,000 $ 570,000 Annual revenues and costs: Sales revenues $ 400,000 $ 480,000 Variable expenses $ 180,000 $ 214,000 Depreciation expense $ 74,000 $ 114,000 Fixed out-of-pocket operating costs $ 88,000 $ 68,000 The company’s discount rate is 20%.

1. Calculate the project profitability index for each product.

2. Calculate the simple rate of return for each product.

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

Answer 1

Solution 1:

Computation of Annual cash inflows
Particulars	Product A	Product B
Sales revenue	$400,000.00	$480,000.00
Variable expenses	$180,000.00	$214,000.00
Fixed Out of pocket operating cost	$88,000.00	$68,000.00
Annual cash inflows	$132,000.00	$198,000.00

Computation of NPV
			Product A		Product B
Particulars	Period	PV Factor	Amount	Present Value	Amount	Present Value
Cash outflows:
Initial investment	0	1	$370,000	$370,000	$530,000	$530,000
Present Value of Cash outflows (A)				$370,000		$530,000
Cash Inflows
Annual cash inflows	1-5	2.991	$132,000	$394,812	$198,000	$592,218
Present Value of Cash Inflows (B)				$394,812		$592,218
Net Present Value (NPV) (B-A)				$24,812		$62,218

Computation of Profitability Index
Particulars	Product A	Product B
NPV	$24,812	$62,218
Initial investment	$370,000	$530,000
Profitability Index (PV of cash inflows / Initial investment)	0.07	0.12

Payback period
Particulars	Choose Numerator	/	Choose Denominator	=	Payback Period
	Initial Investment	/	Annual Cash inflows	=	Payback Period
Product A	$370,000.00	/	$132,000.00	=	2.80	Years
Product B	$570,000.00	/	$198,000.00	=	2.88	Years

Solution 2:

Computation of Annual Operating income
Particulars	Product A	Product B
Annual cash inflows	$132,000.00	$198,000.00
Less: depreciation	$74,000.00	$114,000.00
Annual operating income	$58,000.00	$84,000.00

Simple rate of return
Particulars	Choose Numerator	/	Choose Denominator	=	Simple rate of return
	Annual operating income	/	Initial investment	=	Simple rate of return
Product A	$58,000.00	/	$370,000.00	=	15.7%
Product B	$84,000.00	/	$570,000.00	=	14.7%

Solution 3:

Product Preference
Payback Period	Product A
Simple rate of return	Product A