Question

EXHIBIT 7B-1 Present Value of $1; 14,- Periods 4% 5% 6% 7% 8% 9% 10% 11% 12% 3% 4% 15% 16% 7% 18% 19% 20% 21% 22% 23% 24% 25% 1 0962 0952 0943 0935 0926 0917 0909 0901 0.893 0.885 0.877 0.870 0862 0.855 0847 0.840 0.833 0.826 0820 0.813 0.806 0.800 10.925 0907 0.890 0.873 0.857 0.842 0.826 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 0.683 0.672 0661 0.650 0.640 10889 0.864 0840 0816 0794 072 0.751 0731 0712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 0.564 0551 0537 0.524 0512 0855 0823 0792 0.763 0735 0708 0683 0.659 0636 0.613 0.592 0.572 0.552 0534 0516 0.499 0482 0467 0.451 0437 0423 0410 0822 0784 0.747 0713 0.681 0650 0621 0593 0.567 0.543 0.519 0.497 0476 0.456 0437 0419 0402 0.386 0370 0355 0341 0328 6 0790 0746 0705 0666 0630 0596 0.564 0.535 0507 0.480 0.456 0432 0410 0.390 0.370 0.352 0.335 0319 0303 0289 0275 026 10760 0.711 0665 0623 0.583 0.547 0.513 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 0.263 0.249 0.235 0222 0.210 0731 067 0627 0.582 0540 0502 0.467 0.434 0.404 0376 0.351 0327 0.305 0.285 0.266 0.249 0.233 0.218 0.204 0191 079 0168 10703 0645 0.592 0544 0.500 0.460 0424 0391 0361 0.333 0308 0.284 0.263 0.243 0.225 0.209 0194 0180 0167 0155 0.144 034 0676 0614 0558 0508 0463 0422 0.386 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0191 0176 0162 0.149 0.137 0126 0116 0107 10650 0585 0527 0475 0429 0388 0350 0.37 0.287 0.261 0.237 0.215 0.195 0.178 0162 0.148 0.135 0.123 012 0103 0094 0088 10625 0.557 0497 0444 0397 0356 0.319 0.286 0.257 0.231 0.208 0.187 0.168 0152 0.137 0.124 012 0.102 0092 0083 0076 006 10601 0530 0469 0415 0368 0326 0.290 0.258 0.229 0.204 0182 0.163 0145 0130 016 0104 0.093 0084 0075 0068 0061 0051 0577 0505 0442 0388 0340 0299 0263 0232 0.205 0181 0.160 0.141 0125 011 0099 0088 0078 0069 0.062 0055 0049 0044 5 0555 0481 0417 0362 0.35 0275 0239 0209 0183 0160 0.140 0123 0108 0.095 0.084 0.074 0065 0.057 0051 0045 0040 003 6 0534 0458 0394 0339 0292 0.252 0218 0188 0163 0141 0123 0.107 0.093 0081 0071 0062 0.054 0047 0042 0036 0032 002 0513 0436 0371 037 0270 0231 0198 0170 0.146 0125 0.108 0.093 0080 0.069 0060 0.052 0.045 0.039 0.034 0030 0026 002 8 0494 0416 0350 0296 0250 0.212 0180 0153 0130 011 0.095 0.081 0069 0059 0051 0.044 0038 0032 0.028 0024 0021 0018 10475 0396 0331 027 0232 0194 0164 0138 0.16 0.098 0.083 0.070 0.060 0.051 0043 0.037 0.031 0.027 0.023 0020 0017 0014 10456 0377 0312 0258 0.25 0178 0.149 0.124 0.104 0.087 0073 0.061 0.051 0043 0.037 0031 0.026 0.022 0.019 0.016 0014 0012 0439 0359 0294 0242 0199 0164 0135 0112 0.093 0.077 0.064 0.053 0.044 0.037 0031 0.026 0.022 0018 0015 0013 001 0004 22 0422 0.342 0278 0226 0184 0150 0123 0101 0.083 0.068 0.056 0.046 0.038 0.032 0.026 0.022 0.018 0.015 0.013 0.011 0009 000) 23 0406 0326 0262 021 0170 0138 012 0091 0074 0.060 0.049 0040 0.033 0027 0022 0.018 0.015 0012 0010 0.009 0007 0004 | 0390 0310 0247 0197 0158 0126 0.102 0082 0066 0.053 0.043 0.035 0.028 0023 0019 0.015 0.013 0.010 0008 0007 0006 000! 25 0.375 0.295 0.233 0184 0146 0.116 0.092 0.074 0.059 0.047 0.038 0.030 0.024 0.020 0.016 0.013 0.010 0.009 0007 0.006 0005 0.00 10.361 0281 0220 072 0.135 0106 0084 0.066 0.053 0.042 0.033 0.026 0.021 007 0.014 0011 0.009 0007 0006 0005 0004 000 10347 0268 0207 0161 0125 0.098 0.076 0.060 0.047 0.037 0.029 0.023 0.018 0.04 0.01 0.009 0.007 0.006 0.005 0.004 0.003 000 10333 0.255 0196 0150 0116 0.090 0069 0.054 0.042 0.033 0.026 0.020 0.016 0.012 0.010 0.008 0.006 0.005 0.004 0003 0002 000 0321 0.243 0185 0141 0107 0.082 0063 0048 0.037 0.029 0.022 0.07 0.014 0.01 0.008 0.006 0005 0.004 0.003 0002 0002 0.00 30 0.308 0231 0174 0131 0.099 0.075 0057 0044 0033 0026 0.020 0.015 0.02 0009 0007 0005 0.004 0003 0003 0002 0002 000 40 0208 0142 0097 0067 0046 0032 0022 0.05 0.01 0.008 0.005 0.004 0003 0002 0001 0.001 0.001 0.000 0.000 0.000 0000 0000

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:
Sales revenues	$	380,000		$	460,000
Variable expenses	$	170,000		$	206,000
Depreciation expense	$	68,000		$	108,000
Fixed out-of-pocket operating costs	$	86,000		$	66,000

The company’s discount rate is 20%.

Click here to view Exhibit 7B-1 and Exhibit 7B-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

Project A:

Initial Investment = $340,000

Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs

Annual Net Income = $380000-170000-68000-86000

Annual Net Income = $56,000

Annual Net Cash flows = Annual Net Income + Depreciation

Annual Net Cash flows = $56,000 + $68,000

Annual Net Cash flows = $124,000

Project B:

Initial Investment = $540,000

Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs

Annual Net Income = $460000-206000-108000-66000

Annual Net Income = $80,000

Annual Net Cash flows = Annual Net Income + Depreciation

Annual Net Cash flows = $80,000 + $108,000

Annual Net Cash flows = $188,000

Answer 1.

Project A:

Payback Period = Initial Investment / Annual Net Cash flows

Payback Period = $340000/124000

Payback Period = 2.74 years

Project B:

Payback Period = Initial Investment / Annual Net Cash flows

Payback Period = $540000/188000

Payback Period = 2.87 years

Answer 2.

Project A:

Net Present Value = -$340,000 + $124,000 * PVA of $1 (20%, 5)

Net Present Value = -$340,000 + $124,000 * 2.9906

Net Present Value = $30834

Project B:

Net Present Value = -$540,000 + $188,000 * PVA of $1 (20%, 5)

Net Present Value = -$540,000 + $188,000 * 2.9906

Net Present Value = $22233

Answer 3.

Project A:

Let IRR be i%

$340,000 = $124,000 * PVA of $1 (i%, 5)

PVA of $1 (i%, 5) = 2.7419

Using table values, i = 24%

So, IRR is 24%

Project B:

Let IRR be i%

$540,000 = $188,000 * PVA of $1 (i%, 5)

PVA of $1 (i%, 5) = 2.8723

Using table values, i = 21.86%

So, IRR is 21.86%

Answer 4.

Product A:

Profitability Index = Net Present Value / Initial Investment

Profitability Index = $30834 / $340,000

Profitability Index = 0.09

Product B:

Profitability Index = Net Present Value / Initial Investment

Profitability Index = $22,233 / $540,000

Profitability Index = 0.04

Answer 5.

Project A:

Simple Rate of Return = Annual Net Income / Initial Investment

Simple Rate of Return = $56,000 / $340,000

Simple Rate of Return = 16.47%

Project B:

Simple Rate of Return = Annual Net Income / Initial Investment

Simple Rate of Return = $80,000 / $540,000

Simple Rate of Return = 14.81%

Answer 6-a.

Net Present Value = Project A

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.