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)	$	280,000		$	480,000
Annual revenues and costs:
Sales revenues	$	330,000		$	430,000
Variable expenses	$	152,000		$	202,000
Depreciation expense	$	56,000		$	96,000
Fixed out-of-pocket operating costs	$	78,000		$	60,000

The company’s discount rate is 14%.

Click here to view Exhibit 12B-1 and Exhibit 12B-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:

• Req 1
• Req 2
• Req 3
• Req 4
• Req 5
• Req 6A
• Req 6B

Calculate the payback period for each product. (Round your answers to 2 decimal places.)

	Product A Product B Payback period years years

Calculate the net present value for each product. (Round your final answers to the nearest whole dollar amount.)

	Product A Product B Net present value

Calculate the internal rate of return for each product. (Round your answer to 1 decimal place i.e. 0.123 should be considered as 12.3%.)

	Product A Product B Internal rate of return % %

• Calculate the project profitability index for each product. (Round your answers to 2 decimal places.)

  	Product A Product B Project profitability index

• Calculate the simple rate of return for each product. (Round your answer to 1 decimal place i.e. 0.123 should be considered as 12.3%.)

  	Product A Product B Simple rate of return % %

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

  	Net Present Value Profitability Index Payback Period Internal Rate of Return Simple Rate of Return

• Based on the simple rate of return, Lou Barlow would likely:

  	Accept Product Aradio button unchecked1 of 3 Accept Product Bradio button unchecked2 of 3 Reject both productsradio button unchecked3 of 3

Answer 1

Product A Product B Preferred 280000 480000 Initial Investment Cost Equipment Annual Revenues and Costs Sales revenue Variable expense Depreciation Expense Fixed out of pocket operating costs Net Income Depreciation Expense Cash flow PV factor @14% for 5 years cumu Present value 330000 430000 -152000 -202000 -56000 -96000 -78000 -60000 44000 72000 56000 96000 100000 168000 3.4331 3.4331 343310 576760.8 Payback period NPV IRR Profitability Index Simple rate of return 2.8 63,310 23.06% 1.226 15.71% 2.857 Product B $ 96,760 Product B 22.11% Product A 1.2 Product A 15% Product A Calculation of Pay back period Pay back period = Initial Investment / Cash flow Product A Product B =280000/100000 =480000/168000 2.8 2.857142857 Calculation of Net Present Value NPV = Present value of cash inflows-Initial investment Product A Product B =343310-280000 =576760-480000 63,310S 96,760 S 3) Calculation of Internal rate of return (IRR) IRR is calculated by equating the sum of present value of future cash flows less initial investment to Zero It iscalculated based on the calculator available in online IRR for Product A = 23.059% IRR for Product B= 22.106% Calculation of Profitability Index Profitability Index = (NPV + Initial Investment)/Initial Investment Product A Product B =63310+280000)/(280000) =(96760+480000)/480000 1.226107143 1.201583333 5) Calculation of Simple rate of return Simple rate of return = Incrimental net operating Income/Initial Investment =44000/280000 =72000/480000 15.71% 15% 6a) Payback period NPV IRR Profitability Index Product B Product B Product A Product A 6b Reject both products A & B determined by his divisions return on investment (23%) exceeded of last three years Simple rate of return is lower than ROI