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 20% 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) Annual revenues and costs: Sales revenues Variable expenses Depreciation expense Fixed out-of-pocket operating costs $200,000 $410,000 $280,000 $132,000 $ 40,000 $73,000 $ 380,000 $182,000 $ 82,000 $ 53,000 The company's discount rate is 18% Click here to view Exhibit 11B-1 and Exhibit 11B-2, to determine the appropriate discount factor(s) using tables. Required: 1. Calculate the payback period for each product. (Round your answers to 2 decimal places.) Product B Product A Payback period years years

Answer 1

Solution 1:

Computation of Annual cash inflows
Particulars	Product A	Product B
Sales revenue	$280,000.00	$380,000.00
Variable expenses	$132,000.00	$182,000.00
Fixed Out of pocket operating cost	$73,000.00	$53,000.00
Annual cash inflows	$75,000.00	$145,000.00

Payback period
Particulars	Choose Numerator	/	Choose Denominator	=	Payback Period
	Initial Investment	/	Annual Cash inflows	=	Payback Period
Product A	$200,000.00	/	$75,000.00	=	2.67	Years
Product B	$410,000.00	/	$145,000.00	=	2.83	Years

Solution 2:

Computation of NPV
			Product A		Product B
Particulars	Period	PV Factor	Amount	Present Value	Amount	Present Value
Cash outflows:
Initial investment	0	1	$200,000	$200,000	$410,000	$410,000
Present Value of Cash outflows (A)				$200,000		$410,000
Cash Inflows
Annual cash inflows	1-5	3.127	$75,000	$234,525	$145,000	$453,415
Present Value of Cash Inflows (B)				$234,525		$453,415
Net Present Value (NPV) (B-A)				$34,525		$43,415

Solution 3:

Computation of Profitability Index
Particulars	Product A	Product B
NPV	$34,525	$43,415
Initial investment	$200,000	$410,000
Profitability Index (PV of cash inflows / Initial investment)	0.17	0.11

Solution 4:

Computation of Annual Operating income
Particulars	Product A	Product B
Annual cash inflows	$75,000.00	$145,000.00
Less: depreciation	$40,000.00	$82,000.00
Annual operating income	$35,000.00	$63,000.00

Simple rate of return
Particulars	Choose Numerator	/	Choose Denominator	=	Simple rate of return
	Annual operating income	/	Initial investment	=	Simple rate of return
Product A	$35,000.00	/	$200,000.00	=	17.5%
Product B	$63,000.00	/	$410,000.00	=	15.4%

Solution 5a:

Product Preference
Payback Period	Product A
Net Present Value	Product B
Profitability index	Product A
Simple rate of return	Product A

Solution 5b:

Based on simple rate of return, lou barlow would likely to reject both the products as it will decrease overall ROI of the division.