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 25 % 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) 370,000 530,000 Annual revenues and costs: 400,000 $180,000 $ 74,000 85,000 Sales revenues Variable expenses Depreciation expense Fixed out-of-pocket operating costs 510,000 $ 250,000 $106,000 $ 72,000 The company's discount rate is 19% Click here to view Exhibit 13B-1 and Exhibit 138-2, 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:

Answer 1

Particulars	Product A	Product B	Preferred
Initial outlay	$     370,000.00	$     530,000.00
Revenue	$          400,000	$          510,000
Less:
Variable Costs	$          180,000	$          250,000
Fixed Costs	$            85,000	$            72,000
Depreciation	$            74,000	$          106,000
EBT	$            61,000	$            82,000
Less:Tax	$                   -	$                  -
EAT	$            61,000	$            82,000
Add: Depreciation	$            74,000	$          106,000
Cash inflows	$          135,000	$          188,000
AF (19%,5)	3.0576	3.0576
PV of CIF	$          412,781	$          574,835
Less: Initial Outlay	$          370,000	$          530,000
NPV	$            42,781	$            44,835	Product B is preferred
IRR	`24.08%	22.74%	Product A is preferred
Payback Period (Initial Investment/annual CIF)	2.74	2.82	Product A is preferred
Project Profitability Index (PV of Future CFs/Initial Outlay)	1.12	1.08	Product A is preferred
Simple rate of return (EAT/Investment)	16.49%	15.47%	Product A is preferred
As we can observe, Lou Barlow would likely not choose to manufacture either of the products because both the products have simple rates of return (or) ROIs are less than his division's ROI(25%) which strives to maintain.
Working Note:
	Product A	Product B
Year 0	$         (370,000)	$        (530,000)
Y1	$          135,000	$          188,000
Y2	$          135,000	$          188,000
Y3	$          135,000	$          188,000
Y4	$          135,000	$          188,000
Y5	$          135,000	$          188,000
IRR	24.08%	22.74%