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 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: Sales revenues $ 400,000 $ 510,000 Variable expenses $ 180,000 $ 250,000 Depreciation expense $ 74,000 $ 106,000 Fixed out-of-pocket operating costs $ 85,000 $ 72,000 The company’s discount rate is 19%. 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.

Answer 1

Computation of Annual cashinflows :- Particulars Product A Product B Sales Revenue 5,10,000 Less: Variable expenses Contribution margin Less: Fixed out-of-pocket operating costs Less: Depreciation expense Net Income Add: Depreciation expense (Non cash expenditure) Annual Cashinflow 4,00,000 1,80,000 2,20,000 85,000 74,000 61,000 74,000 2,50,000 2,60,000 72,000 1,06,000 82,000 1,06,000 1,35,000 1,88,000

Computation of Payback Period: Product A Year Cash Cumulative flows $ (3,70,000) 1,35,000 1,35,000 1,35,000 1,35,000 1,35,000 Cash flows $ (3,70,000) (2,35,000) (1,00,000) 35,000 1,70,000 3,05,000 Product B Cumulative Cash flows $ s Cash flows as $ (5,30,000) (5,30,000) 1,88,000 (3,42,000) 1,88,000 (1,54,000) 1,88,000 34,000 1,88,000 2,22,000 1,88,000 4,10,000 Payback period for Product A is = 2 years +(100000/135000) Payback period for Product A is = 2.74 years Payback period for Product B is = 2 years +(154000/188000) Payback period for Product B is = 2.82 years