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 $ 390,000 $ 585,000 Initial investment: Cost of equipment (zero salvage value) Annual revenues and costs: Sales revenues Variable expenses Depreciation expense Fixed out-of-pocket operating costs $ 420,000 $ 185,000 $ 78,000 $ 90,000 $500,000 $ 222,000 $ 117,000 $ 70,000 The company's discount rate is 21%. 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:

Answer 1

Answer with working notes is given below

Sales Less: Variable cost Out of pocket fixed cost Net Annual cash inflows Product A $420,000 $185,000 $90,000 $145,000 Product B $500,000 $222,000 $70,000 $208,000 Years Years 1 Payback period Initial investment Annual cash inflows $390,000 $145,000 2.69 $585,000 $208,000 2.81 2 Calculation of Net present value Net Annual cash inflows PV factor of 21% for 5 years Present value of cash inflows Less: Initial investment Net present value Product A $145,000 2.9260 $424,268 $390,000 $34,268 Product B $208,000 2.9260 $608,605 $585,000 $23,605 3 Internal Rate of Return Year 0 Year 1 Year 2 Product A -$390,000 $145,000 $145,000 $145,000 $145,000 $145,000 25.0% Product B -$585,000 $208,000 $208,000 $208,000 $208,000 $208,000 Year 3 Year 4 Year 5 Internal Rate of Return 22.8% Profitability index Present value of cash inflows Present value of cash outflows Product A $424,268 $390,000 1.09 Product B $608,605 $585,000 1.04 5 Simple rate of return Sales Less: Variable cost Out of pocket fixed cost Depreciation Net Income Initial investment Simple rate of return Product A $420,000 $185,000 $90,000 $78,000 $67,000 $390,000 17.2% Product B $500,000 $222,000 $70,000 $117,000 $91,000 $585,000 15.6% Net present Profitability value index Payback Period Internal Rate of Return Simple Rate of Return Product A Product Product Product A Product A 6b) Based on simple return Product A would be preferred