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 23% 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) $ 310,000 $ 510,000 Annual revenues and costs: Sales revenues $ 360,000 $ 460,000 Variable expenses $ 164,000 $ 214,000 Depreciation expense $ 62,000 $ 102,000 Fixed out-of-pocket operating costs $ 81,000 $ 61,000 The company’s discount rate is 21%. 1. Calculate the payback period for each product. . 2.Calculate the net present value for each product. 3. Calculate the project profitability index for each product. 4. Calculate the simple rate of return for each product.

Answer 1

Answer:

Project A:

Initial Investment = $310,000

Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $360,000 - $164,000 - $62,000 - $81,000
Annual Net Income = $53,000

Annual Net Cash flows = Annual Net Income + Depreciation
Annual Net Cash flows = $53,000 + $62,000
Annual Net Cash flows = $115,000

Project B:

Initial Investment = $510,000

Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $460,000 - $214,000 - $102,000 - $61,000
Annual Net Income = $83,000

Annual Net Cash flows = Annual Net Income + Depreciation
Annual Net Cash flows = $83,000 + $102,000
Annual Net Cash flows = $185,000

Answer 1.

Project A:

Payback Period = Initial Investment / Annual Net Cash flows
Payback Period = $310,000 / $115,000
Payback Period = 2.70 years

Project B:

Payback Period = Initial Investment / Annual Net Cash flows
Payback Period = $510,000 / $185,000
Payback Period = 2.76 years

Answer 2.

Project A:

Net Present Value = -$310,000 + $115,000 * PVA of $1 (21%, 5)
Net Present Value = -$310,000 + $115,000 * 2.9260
Net Present Value = $26,490

Project B:

Net Present Value = -$510,000 + $185,000 * PVA of $1 (21%, 5)
Net Present Value = -$510,000 + $185,000 * 2.9260
Net Present Value = $31,310

Answer 3.

Project A:

Profitability Index = Net Present Value / Initial Investment
Profitability Index = $26,490 / $310,000
Profitability Index = 0.09

Product B:

Profitability Index = Net Present Value / Initial Investment
Profitability Index = $31,310 / $510,000
Profitability Index = 0.06

Answer 4.

Project A:

Simple Rate of Return = Annual Net Income / Initial Investment
Simple Rate of Return = $53,000 / $310,000
Simple Rate of Return = 17.10%

Project B:

Simple Rate of Return = Annual Net Income / Initial Investment
Simple Rate of Return = $83,000 / $510,000
Simple Rate of Return = 16.27%