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) | $ | 250,000 | $ | 460,000 | |
Annual revenues and costs: | |||||
Sales revenues | $ | 300,000 | $ | 400,000 | |
Variable expenses | $ | 135,000 | $ | 190,000 | |
Depreciation expense | $ | 50,000 | $ | 92,000 | |
Fixed out-of-pocket operating costs | $ | 75,000 | $ | 55,000 | |
The company’s discount rate is 18%.
Click here to view Exhibit 13B-1 and Exhibit 13B-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:
Project A:
Initial Investment = $250,000
Net Income = Sales Revenues - Variable Expenses - Depreciation
Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $300,000 - $135,000 - $50,000 - $75,000
Annual Net Income = $40,000
Annual Net Cash flows = Annual Net Income + Depreciation
Annual Net Cash flows = $40,000 + $50,000
Annual Net Cash flows = $90,000
Project B:
Initial Investment = $460,000
Net Income = Sales Revenues - Variable Expenses - Depreciation
Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $400,000 - $190,000 - $92,000 - $55,000
Annual Net Income = $63000
Annual Net Cash flows = Annual Net Income + Depreciation
Annual Net Cash flows = $63,000 + $92,000
Annual Net Cash flows = $155,000
Answer 1.
Project A:
Payback Period = Initial Investment / Annual Net Cash
flows
Payback Period = $250,000 / $90000
Payback Period = 2.77 years
Project B:
Payback Period = Initial Investment / Annual Net Cash
flows
Payback Period = $460,000 / $155,000
Payback Period = 2.96 years
Answer 2.
Project A:
Net Present Value = -$250,000 + $90000 * PVA of $1 (18%,
5)
Net Present Value = -$250,000 + $90,000 * 3.1272
Net Present Value = $531445.39
Project B:
Net Present Value = -$460,000 + $155,000 * PVA of $1 (18%,
5)
Net Present Value = -$460,000 + $155,000 * 3.1272
Net Present Value = $944716
Answer 3.
Project A:
Let IRR be i%
$250,000 = $90,000 * PVA of $1 (i%, 5)
PVA of $1 (i%, 5) = 2.69565
Using table values, i = 25%
So, IRR is 25%
Project B:
Let IRR be i%
$460000 = $155,000 * PVA of $1 (i%, 5)
PVA of $1 (i%, 5) = 2.81768
Using table values, i = 23%
So, IRR is 23%
Answer 4.
Product A:
Profitability Index = Net Present Value / Initial
Investment
Profitability Index = $531445 / $250,000
Profitability Index = 2.125
Product B:
Profitability Index = Net Present Value / Initial
Investment
Profitability Index = $944716 / $460,000
Profitability Index = 2.053
Answer 5.
Project A:
Simple Rate of Return = Annual Net Income / Initial
Investment
Simple Rate of Return = $40,000 / $250,000
Simple Rate of Return = 16%
Project B:
Simple Rate of Return = Annual Net Income / Initial
Investment
Simple Rate of Return = $63,000 / $460,000
Simple Rate of Return = 13.69%
Answer 6-a.
Net Present Value = Project B
Profitability Index = Project A
Payback Period = Project A
Internal Rate of Return = Project A
Simple Rate of Return = Project A
Answer 6-b.
Based on the simple rate of return, Lou Barlow would not accept any project as simple rate of return is lower than the return on investment.
Lou Barlow, a divisional manager for Sage Company, has an opportunity to manufacture and sell one...
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 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) $ 340,000 $ 540,000 Annual revenues and costs:...
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 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) $ 340,000 $ 540,000 Annual revenues and costs:...
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 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) $ 340,000 $ 540,000 Annual revenues and costs:...
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 19% each of the last three years. He has computed the cost and revenue estimates for each product as follows: Product A Product B $ 190,000 $ 400,000 Initial investment: Cost of equipment (zero salvage value) Annual revenues and...
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:...
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:...
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) $ 340,000 $ 525,000 Annual revenues and costs:...
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) $ 290,000 $ 490,000 Annual revenues and costs:...
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 19% 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) $ 190,000 $ 400,000 Annual revenues and costs:...
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 19% each of the last three years. He has computed the cost and revenue estimates for each product as follows: Product A Product B $190,000 $400,000 Initial investment: Cost of equipment (zero salvage value) Annual revenues and costs: Sales...