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 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 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

Workings Product Product B $ 3,40,000.00 $ 5,40,000.00 PARTICULARS Initial investment Cost of equipment (zero salvage value) Annual revenues and costs: Sales revenues Variable expenses Depreciation expense Fixed out-of-pocket operating costs Net Income PV FACTOR @20% 0.8333 3,80,000.00 $ 1,70,000.00 $ 68,000.00 $ 86,000.00 $ 56,000.00 $ 4,60,000.00 2,06,000.00 1,08,000.00 66,000.00 80,000.00 0.6944 0.5787 0.4323 0.4019 2.9905 A.Cash Flow Net Income + Depreciation expense 1,24,000.00 $ 1,88,000.00 B.PV Factor @20% for $1 for 5 years Cumulative 2.9906 2.9906 C.Present Value (A+B) $ 3,70,835.91 $ 5,62,235.08 solution Payback Period = Initial Investment/Net Cash Flow per Period Product A =$ 340000 / 124000 2.74 Product B $540000 / 124000 2.87 Product B is prefered Net present value = Present value of Cash inflows - Initial Investment Product A $ 370835.91 - 340000 30835.91 Product B = $ 562235.08-540000 22285.08 Product Als prefered CALCULATION 1 product A PV FACTOR @18% 0.8475 Internal rate of return For calculating internal rate of first we have to calculate net present value in different discounting rates then formula will be -Lower Discounting rate +( NPV In lower rate/NPV in lower rate-NPV in higher rate) diffrents in discounting rate) PRODUCT A(SEE CALCULATION 2) = 18 +(47769.21/54298.49 )*71) 24.158 0.7182 0.6086 PV FACTOR @25% 0.8000 0.6400 0.5120 0.4096 0.3277 2.6893 0.5158 0.4371 3.1272 PRODUCT (SEE CALCULATION 2) (18+(47508.15/82323.51 )*7) 22.074 present value $3,87,769.21 $ 3,33,470.72 340000 340000 initial investments Net present value $ 6,529.28 $ 47,769.21 $ 54,298.49 Profitability index = Present value of Cash inflows / Initial Investment Product A $370835.91 / $340000 1.091 Product B =$552235.08 / $540000 1.041 Product Als prefered CALCULATION 2 product B PV FACTOR 18% PV FACTOR @25% Simple rate of return=Incremental net income / Initial investment Product A $56000 / $ 340000)*100 Product B = ($ 80000/$ 540000) 100 0.8475 16.471 14.815 0.7182 3 0.6086 0.8000 0.6400 0.5120 0.4096 0.3277 2.6893 Payback Period Net present value Internal rate of return Product B is prefered Product Als prefered Product Als prefered Product Als prefered 0.5153 0.4371 3.1272 Profitability index present value $5,87,908.15 $ 5,05,584.64 simple rate of return for both Product A and B are lower than 22% So Reject both Product A Product B. determined by his division's return on investment (ROI), which has exceeded 22% each of the last three years initial investments Net present value $5,40,000.00 $ 47,908.15 $ 82.323.51 $ $ 5,40,000.00 -34,415.36