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 21% each of the last three years. He has computed the cost and revenue estimates for each product as follows: Product A Product B $270,000 $480,000 Initial investment: Cost of equipment (zero salvage value) Annual revenues and costs: Sales revenues Variable expenses Depreciation expense Fixed out-of-pocket operating costs $320,000 $148,000 $ 54,000 $ 77,000 $420,000 $198,000 $ 96,000 $ 57,000 The company's discount rate is 19%.

Answer 1

Solution 1:

Computation of Annual cash inflows
Particulars	Product A	Product B
Sales revenue	$320,000.00	$420,000.00
Variable expenses	$148,000.00	$198,000.00
Fixed Out of pocket operating cost	$77,000.00	$57,000.00
Annual cash inflows	$95,000.00	$165,000.00

Payback period
Particulars	Choose Numerator	/	Choose Denominator	=	Payback Period
	Initial Investment	/	Annual Cash inflows	=	Payback Period
Product A	$270,000.00	/	$95,000.00	=	2.84	Years
Product B	$480,000.00	/	$165,000.00	=	2.91	Years

Solution 2:

Computation of NPV
			Product A		Product B
Particulars	Period	PV Factor (19%)	Amount	Present Value	Amount	Present Value
Cash outflows:
Initial investment	0	1	$270,000	$270,000	$480,000	$480,000
Present Value of Cash outflows (A)				$270,000		$480,000
Cash Inflows
Annual cash inflows	1-5	3.058	$95,000	$290,510	$165,000	$504,570
Present Value of Cash Inflows (B)				$290,510		$504,570
Net Present Value (NPV) (B-A)				$20,510		$24,570

Solution 3:

Computation of IRR
Period	Product A		Product B
	Cash Flows	IRR	Cash Flows	IRR
0	-$270,000.00	22.4%	-$480,000.00	21.3%
1	$95,000.00		$165,000.00
2	$95,000.00		$165,000.00
3	$95,000.00		$165,000.00
4	$95,000.00		$165,000.00
5	$95,000.00		$165,000.00

Solution 4:

Computation of Profitability Index
Particulars	Product A	Product B
NPV	$20,510	$24,570
Initial investment	$270,000	$480,000
Profitability Index (PV of cash inflows / Initial investment)	0.08	0.05

Solution 5:

Computation of Annual Operating income
Particulars	Product A	Product B
Annual cash inflows	$95,000.00	$165,000.00
Less: depreciation	$54,000.00	$96,000.00
Annual operating income	$41,000.00	$69,000.00

Simple rate of return
Particulars	Choose Numerator	/	Choose Denominator	=	Simple rate of return
	Annual operating income	/	Initial investment	=	Simple rate of return
Product A	$41,000.00	/	$270,000.00	=	15.2%
Product B	$69,000.00	/	$480,000.00	=	14.4%

Solution 6a:

Product Preference
Payback Period	Product A
Net Present Value	Product B
IRR	Product A
Profitability index	Product A
Simple rate of return	Product A

Solution 6b:

Based on simple rate of return, lou barlow would likely to reject both the products as it will decrease overall ROI of the division.