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 ralses are determined by his division's return on investment (RO), 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) Annual revenues and costs: Sales revenues Variable expenses Depreciation expense Fixed out-of-pocket operating costs $ 370,000 $570,000 $ 400,000 $ 180,000 $ $ 480,000 $ 214,000 $ 114,e00 68,000 74,000 $ 88,000 $ The company's discount rate is 20 % Click here to view Exhibit 128-1 and Exhibit 128-2, 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

product A product I initial investment Cost of equipment |annual revenues and costs: |sales revenues variable expenses depreciation expense fixed out of pocket operating costs $370,000 570,000 $ 400,000 $480,000 $ 180,000 214,000 $ 74,000 114,000 88,000 68,000 payback period product A product I $ 400,000 $ 480,000 $180,000 214,000 |sales revenues variable expenses fixed out of pocket operating costs annual net cash inflows 68,000 88,000 $ 132,000 $198,000 Cost of equipment 370,000 $ 570,000 payback period cost of equipment /annual net cash inflows payback period (years) = 2.80 2.88 decision prefer product A

2 net present value product A product B $132,000 $ 198,000 annual net cash inflows PVAF (20%, 5 years) present value of net cash inflows - initial cash outflow =net present value 2.991 2.991 $ 394,812 $592,218 $ 370,000 570,000 $24,812 $ 22,218 decision prefer product A 3internal rate of return product A product B $(370,000) $(570,000) $132,000 198,000 $132,000 198,000 $ 132,000 198,000 $132,000 198,000 $ 132,000 198,000 year 0 1 2 5 internal rate of return 23.0% 21.8% decision prefer product A ח

4 profitability index profitability index present value of cash inflows /present value of cash outflows product A product B present value of net cash inflows present value of cash outflows profitability index $ 394,812 $592, 218 370,000 570,000 1.07 1.04 decision prefer product A 5 simple rate of return simple rate of return annual income initial cost product A product B annual net cash inflows $ 132,000 $198,000 $ 74,000 $114,000 |- depreciation $58,000 84,000 annual income $ 370,000 570,000 initial cost simple rate of return 15.7% 14.7% decision prefer product A

prefer product A ба payback period net present value internal rate of return profitability index simple rate of return product A product A product A product A based on simple rate of return, Lou Barlow would likely reject both products 6b because ROI of both of them is less than the desired ROI of 22%